Lecture 8

Aggregate Demand in the Goods and Money Markets

Planned Investment and the Interest Rate

Other Determinants of Planned Investment
Planned Aggregate Expenditure and the Interest Rate

Equilibrium in Both the Goods and Money Markets

Policy Effects in the Goods and Money Markets

Expansionary Policy Effects
Contractionary Policy Effects
The Macroeconomic Policy Mix

The Aggregate Demand (AD) Curve

The Aggregate Demand Curve: A Warning
Other Reasons for a Downward-Sloping Aggregate Demand Curve
Aggregate Expenditure and Aggregate Demand
Shifts of the Aggregate Demand Curve
1 of 37
Aggregate Demand in the Goods and Money Markets

goods market The market in which goods and

services are exchanged and in which the
equilibrium level of aggregate output is
determined.

money market The market in which financial

instruments are exchanged and in which the
equilibrium level of the interest rate is determined.

2 of 37
Planned Investment and the Interest Rate

 FIGURE 12.1 Planned Investment Schedule

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.

3 of 37
Planned Investment and the Interest Rate
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, its expectation of
future sales.

The optimism or pessimism of entrepreneurs

about the future course of the economy can have
an important effect on current planned investment.
Keynes used the phrase animal spirits to describe
the feelings of entrepreneurs, and he argued that
these feelings affect investment decisions.

4 of 37
Planned Investment and the Interest Rate
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 planned aggregate expenditure is the

sum of consumption, planned investment, and
government purchases.

AE ≡ C + I + G

5 of 37
Planned Investment and the Interest Rate
Planned Aggregate Expenditure and the Interest Rate

 FIGURE 12.2 The Effect of an Interest Rate Increase on Planned Aggregate Expenditure
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.
6 of 37
Planned Investment and the Interest Rate
Planned Aggregate Expenditure and the Interest Rate

The effects of a change in the interest rate include:

 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 (income)
(Y) by a multiple of the initial decrease in
planned investment.

7 of 37
Planned Investment and the Interest Rate
Planned Aggregate Expenditure and the Interest Rate

Using a convenient shorthand:

r  I  AE  Y 

r  I  AE  Y 

8 of 37
Equilibrium in Both the Goods and Money Markets

An increase in the interest rate (r) decreases output

(Y) in the goods market because an increase in r
lowers planned investment.

When income (Y) increase, this shifts the money

demand curve 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

9 of 37
Equilibrium in Both the Goods and Money Markets

 FIGURE 12.3 Links Between the Goods Market and the Money Market
Planned investment depends on the interest rate, and money demand depends on aggregate output.

10 of 37
Policy Effects in the Goods and Money Markets
Expansionary Policy Effects

expansionary fiscal policy An increase in

government spending or a reduction in net taxes
aimed at increasing aggregate output (income)
(Y).

expansionary monetary policy An increase in

the money supply aimed at increasing aggregate
output (income) (Y).

11 of 37
Policy Effects in the Goods and Money Markets
Expansionary Policy Effects

Expansionary Fiscal Policy: An Increase in Government

Purchases (G) or a Decrease in Net Taxes (T)

crowding-out effect The tendency for increases

in government spending to cause reductions in
private investment spending.

12 of 37
Policy Effects in the Goods and Money Markets
Expansionary Policy Effects

Expansionary Fiscal Policy: An Increase in Government

Purchases (G) or a Decrease in Net Taxes (T)

 FIGURE 12.4 The

Crowding-Out Effect
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.

13 of 37
Policy Effects in the Goods and Money Markets
Expansionary Policy Effects

Expansionary Fiscal Policy: An Increase in Government

Purchases (G) or a Decrease in Net Taxes (T)

interest sensitivity or insensitivity of planned

investment The responsiveness of planned
investment spending to changes in the interest
rate. Interest sensitivity means that planned
investment spending changes a great deal in
response to changes in the interest rate; interest
insensitivity means little or no change in planned
investment as a result of changes in the interest
rate.

Effects of an expansionary fiscal policy:

G  Y  M d  r  I 
Y increases less than if r did not increase
14 of 37
Policy Effects in the Goods and Money Markets
Expansionary Policy Effects

Expansionary Monetary Policy: An Increase in the

Money Supply

Effects of an expansionary monetary policy:

M s  r  I  Y  M d 
d
r decreases less than if M did not increase

15 of 37
Policy Effects in the Goods and Money Markets
Contractionary Policy Effects

Contractionary Fiscal Policy: A Decrease in Government

Spending (G) or an Increase in Net Taxes (T)

contractionary fiscal policy A decrease in

government spending or an increase in net taxes
aimed at decreasing aggregate output (income)
(Y).

Effects of a contractionary fiscal policy:

G  or T  Y  M d  r  I 
Y decreases less than if r did not decrease

16 of 37
Policy Effects in the Goods and Money Markets
Contractionary Policy Effects

Contractionary Monetary Policy: A Decrease in the

Money Supply

contractionary monetary policy A decrease in

the money supply aimed at decreasing aggregate
output (income) (Y).

Effects of a contractionary monetary policy:

M s  r  I  Y  M d 
d
r increases less than if M did not decrease

17 of 37
Policy Effects in the Goods and Money Markets
The Macroeconomic Policy Mix

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
Y , r ?, I ?,C  Y ?,r , I , C ?
( M s )
Monetary
Policy
Contractio nary
Y ?,r , I , C ? Y , r ?, I ?,C 
( M s )
Key :
: Variable increases.
: Variable decreases.
? : Forces push the variable in differentdirections. Without additional information, w ecannot
specify w hichw aythe variable moves.

18 of 37
The Aggregate Demand (AD) Curve

aggregate demand The total demand for goods

and services in the economy.

aggregate demand (AD) curve A curve that

shows the negative relationship between
aggregate output (income) and the price level.
Each point on the AD curve is a point at which
both the goods market and the money market are
in equilibrium.

19 of 37
The Aggregate Demand (AD) Curve

 FIGURE 12.5 The Impact of an Increase in the Price Level on the Economy—Assuming No
Changes in G, T, and Ms
This figure shows that when P increases, Y decreases.

20 of 37
The Aggregate Demand (AD) Curve

 FIGURE 12.6 The Aggregate

Demand (AD) Curve
At all points along the AD curve, both
the goods market and the money
market are in equilibrium. The policy
variables G, T, and Ms are fixed.

21 of 37
The Aggregate Demand (AD) Curve
The Aggregate Demand Curve: A Warning

It is important that you realize what the aggregate

demand curve represents.

The aggregate demand curve is more complex

than a simple individual or market demand curve.
The AD curve is not a market demand curve, and
it is not the sum of all market demand curves in
the economy.

To understand what the aggregate demand curve

represents, you must understand the interaction
between the goods market and the money
markets.

22 of 37
The Aggregate Demand (AD) Curve
Other Reasons for a Downward-Sloping Aggregate Demand Curve

The Consumption Link

The consumption link provides another reason for

the AD curve’s downward slope.

An increase in the price level increases the

demand for money, which leads to an increase in
the interest rate, which leads to a decrease in
consumption (as well as planned investment),
which leads to a decrease in aggregate output
(income).

23 of 37
The Aggregate Demand (AD) Curve
Other Reasons for a Downward-Sloping Aggregate Demand Curve

The Consumption Link

The initial decrease in consumption (brought about

by the increase in the interest rate) contributes to
the overall decrease in output.

Planned investment does not bear all the burden

of providing the link from a higher interest rate to a
lower level of aggregate output.

Decreased consumption brought about by a higher

interest rate also contributes to this effect.

24 of 37
The Aggregate Demand (AD) Curve
Other Reasons for a Downward-Sloping Aggregate Demand Curve

The Real Wealth Effect

real wealth, or real balance, effect The change

in consumption brought about by a change in real
wealth that results from a change in the price level.

25 of 37
The Aggregate Demand (AD) Curve
Aggregate Expenditure and Aggregate Demand

At equilibrium, planned aggregate expenditure

(AE ≡ C + I + G) and aggregate output (Y) are
equal:

equilibrium condition: C + I + G = Y

26 of 37
The Aggregate Demand (AD) Curve
Shifts of the Aggregate Demand Curve

 FIGURE 12.7 The Effect of an

Increase in Money Supply on the AD
Curve

An increase in the money supply (Ms)

causes the aggregate demand curve to
shift to the right, from AD0 to AD1. This
shift occurs because the increase in
Ms lowers the interest rate, which
increases planned investment (and
thus planned aggregate expenditure).
The final result is an increase in output
at each possible price level.

27 of 37
The Aggregate Demand (AD) Curve
Shifts of the Aggregate Demand Curve

 FIGURE 12.8 The Effect of an

Increase in Government Purchases or a
Decrease in Net Taxes on the AD Curve

An increase in government purchases

(G) or a decrease in net taxes (T)
causes the aggregate demand curve to
shift to the right, from AD0 to AD1. The
increase in G increases planned
aggregate expenditure, which leads to
an increase in output at each possible
price level. A decrease in T causes
consumption to rise. The higher
consumption then increases planned
aggregate expenditure, which leads to
an increase in output at each possible
price level.

28 of 37
The Aggregate Demand (AD) Curve
Shifts of the Aggregate Demand Curve

 FIGURE 12.9 Factors That Shift the Aggregate Demand Curve

29 of 37
REVIEW TERMS AND CONCEPTS

aggregate demand
aggregate demand (AD) curve
contractionary fiscal policy
contractionary monetary policy
crowding-out effect
expansionary fiscal policy
expansionary monetary policy
goods market
interest sensitivity or insensitivity of planned
investment
money market
policy mix
real wealth, or real balance, effect

30 of 37
 APPENDIX A
THE IS-LM DIAGRAM
THE IS CURVE

An IS curve illustrates the negative relationship

between the equilibrium value of aggregate output
(income) (Y) and the interest rate in the goods
market.

 FIGURE 12A.1 The IS Curve

Each point on the IS curve

corresponds to the equilibrium
point in the goods market for
the given interest rate.
When government spending (G)
increases, the IS curve shifts to
the right, from IS0 to IS1.

31 of 37
 APPENDIX A
THE IS-LM DIAGRAM
THE LM CURVE

An LM curve illustrates the positive relationship

between the equilibrium value of the interest rate
and aggregate output (income) (Y) in the money
market.

 FIGURE 12A.2 The LM Curve

Each point on the LM curve

corresponds to the equilibrium
point in the money market for
the given value of aggregate
output (income).
Money supply (Ms) increases
shift the LM curve to the right,
from LM0 to LM1.

32 of 37
 APPENDIX A
THE IS-LM DIAGRAM
THE IS-LM DIAGRAM

The IS-LM diagram is a way of depicting

graphically the determination of aggregate output
(income) and the interest rate in the goods and
money markets.

 FIGURE 12A.3 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.

33 of 37
 APPENDIX A
THE IS-LM DIAGRAM
THE IS-LM DIAGRAM

 FIGURE 12A.4 An Increase in Government Purchases (G)

When G increases, the IS curve shifts to the right.

This increases the equilibrium value of both Y and r.
34 of 37
 APPENDIX A
THE IS-LM DIAGRAM
THE IS-LM DIAGRAM

 FIGURE 12A.5 An Increase in the Money Supply (Ms)

When Ms increases, the LM curve shifts to the right.

This increases the equilibrium value of Y and decreases the equilibrium value of r.
35 of 37