Transcript Principles of Economics, Case and Fair,9e

PART III THE CORE OF MACROECONOMIC THEORY
12
Aggregate Demand
in the Goods and
Money Markets
CHAPTER OUTLINE
Planned Investment and the Interest Rate
Equilibrium in Both the Goods and Money
Markets
Policy Effects in the Goods and Money
Markets
The Aggregate Demand (AD) Curve
Adapted from:
Fernando & Yvonn Quijano
© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster
CHAPTER 12 Aggregate Demand in the Goods and Money Markets
In Chapters 8 & 9, we focused on the goods market, exploring how the
equilibrium level of aggregate output (Y) is determined.
Y=C+I+G
In Chapters 10 & 11, we looked at the money market, examining how
the equilibrium level of interest rate (r) is determined.
Md = Ms
However, the goods and money markets do not operate independently.
Events in one market have effects on the other.
In this chapter, we will bring the two markets together, in so doing
explaining the links between Y and r. We also derive the aggregate
demand (AD) curve, which explores the relation between Y and the
price level (P).
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
12.1 Planned Investment and the Interest Rate
In Chapters 8 & 9, we assumed for
simplicity, that planned investment is
fixed.
In practice, planned investment
spending is a negative function of the
interest rate.
An increase in the interest rate from 3
percent to 6 percent reduces planned
investment from I0 to I1.
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
Other Determinants of Planned Investment
The assumption that planned investment depends only on the interest
rate is obviously a simplification, just as is the assumption that
consumption depends only on income.
In practice, the decision of a firm on how much to invest depends on,
among other things:
• expectation of future sales
• capital utilization rates
• relative capital and labor costs
• productive technology
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
Planned Aggregate Expenditure and the Interest Rate
We can use the fact that planned investment depends on the interest
rate to consider how planned aggregate expenditure (AE) depends on
the interest rate.
Recall that:
AE ≡ C + I + G
r  I  AE  Y 
r  I  AE  Y 
A negative relationship exists between r and Y in
the goods market.
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
Planned Aggregate Expenditure and the Interest Rate
An increase in the interest rate from
3 percent to 6 percent lowers
planned aggregate expenditure and
thus reduces equilibrium income
from Y0 to Y1.
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The effects of an increase in interest rate from 3% to 6% include:
CHAPTER 12 Aggregate Demand in the Goods and Money Markets
 A high interest rate (r) discourages planned investment (I).
 Planned investment is a part of planned aggregate expenditure
(AE).
 Thus, when the interest rate rises, planned aggregate expenditure
(AE) at every level of income falls.
 Finally, a decrease in planned aggregate expenditure lowers
equilibrium output Y by a multiple of the initial decrease in planned
investment (investment multiplier).
To recall, any changes to Md or Ms in the money market will change
the equilibrium interest rate r. However, the effect is not confined to
the money market, but will spillover to the goods market via planned
investment (I). Eventually, equilibrium output Y will be affected.
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
12.2 Equilibrium in Both the Goods and Money Markets
However, when income (Y) increases, it affects the equilibrium in the
money market. That is, the money demand curve shifts to the right,
which increases the interest rate (r) with a fixed money supply. We
can thus write:
Y  M d  r 
Y  M  r 
d
A positive relationship exists between r and Y in the
money market.
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
In the goods market, for a given value of r, we can determine the equilibrium
value of Y (because I depends on r).
In the money market, for a given value of Y, we can determine the
equilibrium value of r (because money demand depends on Y).
How do we find the one pair of Y and r that achieves overall equilibrium in
both the goods and money markets? (We will use the IS-LM curves)
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
The IS Curve
In the goods market:
When r , Y 
When r , Y 
There exists a negative relationship between
the equilibrium value of Y and r (IS curve)
Each point on the IS
curve represents the
equilibrium point in
the goods market
for a given r.
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
The LM Curve
In the money market:
When Y , r 
When Y , r 
There exists a positive relationship between the
equilibrium value of r and Y (LM curve)
Each point on the LM
curve represents the
equilibrium point in
the money market
for a given Y.
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
The IS-LM Diagram
The point at which the IS and LM curves intersect corresponds to
the point at which both the goods market and the money market are
in equilibrium.
The equilibrium values
of aggregate output
and the interest rate
are Y0 and r0.
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
12.3 Expansionary Policy Effects in the Goods and Money Markets
expansionary fiscal policy An increase in government spending or
a reduction in net taxes aimed at increasing aggregate output (Y).
expansionary monetary policy An increase in the money supply
aimed at increasing aggregate output (Y).
(1) Expansionary Fiscal Policy: An Increase in G or a Decrease in T
Goods Market
G  (fromG0 toG1 )  AE Y  (fromY0 to Y1 )
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
Money Market
Y  M d  r 
Goods Market
r  I  (crowding- out effect) AE Y  (fromY1 to Y* )
An expansionary fiscal policy tends to lead to a
crowding-out effect. In this case, the reductions in
private investment spending (I).
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
An increase in
government spending G
from G0 to G1 shifts the
planned aggregate
expenditure schedule
from 1 to 2.
The crowding-out effect
of the decrease in
planned investment
(brought about by the
increased interest rate)
then shifts the planned
aggregate expenditure
schedule from 2 to 3.
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
The size of the crowding-out effect depends on:
1) The action of the central bank in the money market. If the central
bank increases money supply simultaneously such that r remains
unchanged, then there would be no crowding out effect.
2) The sensitivity of planned investment to changes in the interest
rate. If the slope of the investment curve is very steep, then there is
little change in I as a result of changes in r.
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
Graphical Depiction via IS-LM Diagram
In the goods market, an increase in G will raise the equilibrium value of Y
at the same level of r.
This implies that the IS curve will shift to the right from IS0 to IS1.
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
So, when the government pursues an expansionary fiscal policy, the IS curve
shifts to the right from IS0 to IS1.
At the new equilibrium point, both the Y and r have increased.
As noted earlier, if r did not increase, there will be no crowding-out effect,
and Y will increase even more.
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(2) Expansionary Monetary Policy: An Increase in Ms
CHAPTER 12 Aggregate Demand in the Goods and Money Markets
Effects of an expansionary monetary policy:
M s  r  I  Y  M d 
r decreases less than if M
d
did not increase
In the money market, an
increase in Ms will
decrease the equilibrium
value of r at the same level
of Y.
This implies that the LM
curve will shift to the right
from LM0 to LM1.
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
So, when the government pursues an expansionary monetary policy, the LM
curve shifts to the right from LM0 to LM1.
At the new equilibrium point, Y increases but r falls.
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
12.4 Contractionary Policy Effects in the Goods and Money Markets
contractionary policies aimed at decreasing aggregate output (Y),
often used to fight inflation.
(1) Contractionary Fiscal Policy: A Decrease in G or an Increase in T
Effects of a contractionary fiscal policy:
G  or T  Y  M d  r  I 
Y decreases less than if r did not decrease
It will be clearer to use the IS-LM Diagram, where the IS curve
shifts to the left. At the new equilibrium point, both Y and r
decrease.
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
(2) Contractionary Monetary Policy: A Decrease in Ms
Effects of a contractionary monetary policy:
M s  r  I  Y  M d 
r increases less than if M
d
did not decrease
It will be clearer to use the IS-LM Diagram, where the LM curve
shifts to the left. At the new equilibrium point, Y decreases but r
increases.
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
12.5 Macroeconomic Policy Mix Effects in the Goods and Money Markets
policy mix The combination of monetary and fiscal policies in use at
a given time.
TABLE 12.1 The Effects of the Macroeconomic Policy Mix
Fiscal Policy
Expansiona ry
Contractio nary
( G or  T )
( G or  T )
Expansiona ry
( M s )
Y , r ?, I ?,C 
Y ?,r , I , C ?
Contractio nary
( M s )
Y ?,r , I , C ?
Y , r ?, I ?,C 
Monetary
Policy
It will be clearer to use the IS-LM Diagram
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
12.6 The Aggregate Demand (AD) Curve
The AD curve shows the equilibrium levels of Y associated with different
price levels (P) in the economy, taking into account the behavior of firms and
households in both the goods and money markets at the same time.
The AD curve is derived by assuming the government does not take any
action (G, T or Ms) to affect the economy in response to changes in P.
The AD curve shows the relation between the aggregate quantity of goods
demanded (C + I + G) and the price level P.
To derive the AD curve, we examine what happens to Y when P changes.
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
 FIGURE 12.5 The Impact of an Increase in the Price Level on the Economy—Assuming No
Changes in G, T, and Ms
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
From the slide, it is clear that:
When P , Y 
When P , Y 
A negative relationship exists between
P and Y.
Each point on the AD curve is
a point at which both the goods
market and the money market
are in equilibrium.
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Alternative: Deriving the AD curve using IS-LM framework
CHAPTER 12 Aggregate Demand in the Goods and Money Markets
For a given price level (P) the aggregate quantity of output demanded is determined
where the IS and LM curves intersect.
For instance, at P0, the equilibrium point is at E, with the corresponding output at Y0.
When P  to P1, the LM curve shifts to the left due to a reduction in real money supply. At
the new equilibrium point of F, the aggregate quantity of output demanded falls from Y0 to
Y1.
LM1 (P = P1)
r
P
LM0 (P = P0)
F
F
E
P0
E
IS
AD
Y1
Y0
Y
Y1
Y0
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Y
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
The Aggregate Demand (AD) Curve: A Warning
The AD curve is more complex than a simple individual or market demand
(DD) curve. The AD curve is not a market demand curve, and it is not the
sum of all market demand curves in the economy.
Even though both the AD and DD curves are download-sloping, the reasons
behind are different.
Why DD curve is downward-sloping?
Substitution effect
 Income effect
Why AD curve is downward-sloping?
Interest rate link. An increase in the price level reduces the real money
supply, and shifts the LM curve to the left. At the new equilibrium point,
interest rate increases, which reduces the demand for goods by
households and firms.
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Other Reasons for a Downward-Sloping AD Curve
CHAPTER 12 Aggregate Demand in the Goods and Money Markets
(1) The Consumption Link
Even though we have assumed that consumption (C) depends only on income
(Y), in practice, interest rates also affect the level of C.
i.e. when r , I  and C  at the same time
So, when P , Md  (shifts to the right), r , C  (and I ), AE , Y 
The consumption link thus explains the negative relationship between P and Y.
(2) The Real Wealth (or Real Balance) Effect
When P , your real wealth  (erosion in purchasing power), C  , AE  , Y 
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
12.7 The Shifts in Aggregate Demand (AD) Curve
The AD curve will shift if any of the
policy variables (Ms, G, T) change.
At a fixed level of P, if Ms , r ,
I and C , AE , Y .
Thus, the AD curve will shift to
the right, from AD0 to AD1.
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
At a fixed level of P, if G , AE , Y 
(though some of the increases will be
crowded out due to a fall in interest
rate in the money market).
Thus, the AD curve will shift to the
right, from AD0 to AD1.
As for a decrease in T, C , AE ,
Y  (again, there will be crowdingout effect from the interaction with
money market).
The AD curve will also shift to the
right, from AD0 to AD1.
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CHAPTER 12 Aggregate Demand in the Goods and Money Markets
Summary: Factors That Shift the AD Curve
The aggregate demand is determined by the intersection of the IS and LM
curves. Hence, holding the price level constant, any factor that causes the
equilibrium point to shift will also move the AD curve in a similar direction.
Please take note that the choice of IS-LM and AD-AS depends on the issue
addressed.
The IS-LM framework relates the interest rate to output; whereas the AD-AS
relates the price level to output.
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