CHAPTER 27 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case,

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© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 1 of 57

PowerPoint Lectures for

Principles of Economics, 9e

By

Karl E. Case, Ray C. Fair & Sharon M. Oster

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© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster

27PART V THE CORE OF MACROECONOMIC THEORY

Aggregate Demand

in the Goods andMoney Markets

Fernando & Yvonn Quijano

Prepared by:

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Planned Investment and the Interest RateOther Determinants of Planned InvestmentPlanned Aggregate Expenditure and the

Interest Rate

Equilibrium in Both the Goods and MoneyMarkets

Policy Effects in the Goods and MoneyMarkets

Expansionary Policy EffectsContractionary Policy EffectsThe Macroeconomic Policy Mix

The Aggregate Demand (AD) CurveThe Aggregate Demand Curve: A WarningOther Reasons for a Downward-Sloping Aggregate Demand CurveAggregate Expenditure and Aggregate DemandShifts of the Aggregate Demand Curve

Looking Ahead: Determining the Price Level

Appendix: The IS-LM Diagram

CHAPTER OUTLINE

Aggregate Demand

in the Goods andMoney Markets

27PART V THE CORE OF MACROECONOMIC THEORY

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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.

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Planned Investment and the Interest Rate

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.

FIGURE 27.1 Planned Investment Schedule

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Reducing the interest rate, ceteris paribus, is likely to:

a. Increase the level of planned investment spending.

b. Decrease the level of planned investment.

c. Shift the demand for money curve to the right.

d. Shift the supply of money curve to the right.

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Reducing the interest rate, ceteris paribus, is likely to:

a.a. Increase the level of planned investment spending.Increase the level of planned investment spending.

b. Decrease the level of planned investment.

c. Shift the demand for money curve to the right.

d. Shift the supply of money curve to the right.

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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.

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Other Determinants of Planned Investment

Interest Rates and Investment Spending

A recent study by Simon Gilchrist, Fabio Natalucci, and Egon Zakrajsek finds that interest rates have a powerful effect on the behavior of firms.

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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

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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.

FIGURE 27.2 The Effect of an Interest Rate Increase on Planned Aggregate Expenditure

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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.

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Fill in the blanks. A higher interest rate __________ planned investment and causes planned aggregate expenditure to shift ___________.

a. increases; upward

b. increases; downward

c. decreases; upward

d. decreases; downward

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Fill in the blanks. A higher interest rate __________ planned investment and causes planned aggregate expenditure to shift ___________.

a. increases; upward

b. increases; downward

c. decreases; upward

d.d. decreases; downwarddecreases; downward

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Using a convenient shorthand:

r I AE Y

r I AE Y

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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:

rMY

rMYd

d

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Which of the following statements describes the relationship between the goods market and the money market?

a. An increase in money demand.

b. An increase in money supply.

c. A decrease in the interest rate.

d. An increase in both the supply and the demand for money.

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Which of the following statements describes the relationship between the goods market and the money market?

a.a. An increase in money demand.An increase in money demand.

b. An increase in money supply.

c. A decrease in the interest rate.

d. An increase in both the supply and the demand for money.

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Equilibrium in Both the Goods and Money Markets

Planned investment depends on the interest rate, and money demand depends on aggregate output.

FIGURE 27.3 Links Between the Goods Market and the Money Market

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Which of the following is a link between the goods market and the money market?

a. Income has considerable influence on the demand for money in the money market.

b. The interest rate has significant effects on planned investment in the goods market.

c. Both a and b above.

d. None of the above. The goods market and the money market are not linked in the ways described above.

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Which of the following is a link between the goods market and the money market?

a. Income has considerable influence on the demand for money in the money market.

b. The interest rate has significant effects on planned investment in the goods market.

c. c. Both a and b above.Both a and b above.

d. None of the above. The goods market and the money market are not linked in the ways described above.

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Policy Effects in the Goods and Money Markets

Expansionary Policy Effects

expansionary fiscal policy An increase ingovernment 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).

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Which of the following policy changes would be considered expansionary monetary policy?

a. An increase in the money supply.

b. An increase in net taxes.

c. An increase in government spending.

d. An increase in government borrowing.

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Which of the following policy changes would be considered expansionary monetary policy?

a.a. An increase in the money supply.An increase in the money supply.

b. An increase in net taxes.

c. An increase in government spending.

d. An increase in government borrowing.

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crowding-out effect The tendency for increases in government spending to cause reductions in private investment spending.

Expansionary Fiscal Policy: An Increase in Government Purchases (G) or a Decrease in Net Taxes (T)

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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.

FIGURE 27.4 The Crowding-Out Effect

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An increase in government spending (G),

a. Increases planned aggregate expenditure, increases aggregate output, but may also cause a decrease in planned investment, which reduces both planned aggregate expenditure and aggregate output.

b. Increases planned aggregate expenditure, increases aggregate output, and spurs even more planned investment, which further increases aggregate output.

c. Decreases aggregate expenditure, planned investment, and aggregate output.

d. All of the cases above have equal chance of occurring.

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An increase in government spending (G),

a.a. Increases planned aggregate expenditure, increases Increases planned aggregate expenditure, increases aggregate output, but may also cause a decrease in aggregate output, but may also cause a decrease in planned investment, which reduces both planned planned investment, which reduces both planned aggregate expenditure and aggregate output.aggregate expenditure and aggregate output.

b. Increases planned aggregate expenditure, increases aggregate output, and spurs even more planned investment, which further increases aggregate output.

c. Decreases aggregate expenditure, planned investment, and aggregate output.

d. All of the cases above have equal chance of occurring.

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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:

increase not did if than less increases rY

IrMYG d

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Expansionary Monetary Policy: An Increase in the Money Supply

Effects of an expansionary monetary policy:

increase not did if than less decreases d

Mr

ds MYIrM

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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:

decrease not did if than less decreases

or

rY

IrMYTG d

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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:

decrease not did if than less increases d

Mr

ds MYIrM

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The Macroeconomic Policy Mix

policy mix The combination of monetary and fiscal policies in use at a given time.

TABLE 27.1 The Effects of the Macroeconomic Policy Mix

Fiscal Policy

MonetaryPolicy

)or (

ryExpansiona

TG )or (

naryContractio

TG

)(

ryExpansionasM

)(

naryContractiosM

CIrY ?,?,, ?,,?, CIrY

?,,?, CIrY CIrY ?,?,,

moves. variable the way which specify

cannot we n,informatio additional Without .directions different in variable the push Forces :?

decreases. Variable :

increases. Variable

:Key

:

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Which policy mix favors investment spending over government spending?

a. Expansionary fiscal policy and contractionary monetary policy.

b. An increase in the money supply and a fall in government purchases.

c. Both expansionary fiscal policy and expansionary monetary policy.

d. None of the above. No policy mix favors investment over government spending.

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Which policy mix favors investment spending over government spending?

a. Expansionary fiscal policy and contractionary monetary policy.

b.b. An increase in the money supply and a fall in An increase in the money supply and a fall in government purchases.government purchases.

c. Both expansionary fiscal policy and expansionary monetary policy.

d. None of the above. No policy mix favors investment over government spending.

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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.

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This figure shows that when P increases, Y decreases.

FIGURE 27.5 The Impact of an Increase in the Price Level on the Economy—Assuming No Changes in G, T, and Ms

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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.

FIGURE 27.6 The Aggregate Demand (AD) Curve

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Let P equal the aggregate price level. Assuming that G, T, and MS remain the same, the impact of an increase in the price level on the economy can be described as follows:

a.

b.

c.

d.

e.

P M r I AEd

P M r I AEd

P M r I AEd

P M r I AEd

P M r I AEd

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Let P equal the aggregate price level. Assuming that G, T, and MS remain the same, the impact of an increase in the price level on the economy can be described as follows:

a.

b.

c.c.

d.

e.

P M r I AEd

P M r I AEd

dP M r I AE

P M r I AEd

P M r I AEd

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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.

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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).

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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.

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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.

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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

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Along the aggregate demand curve, each point represents:

a. Equilibrium in the goods market, regardless of the equilibrium situation in the money market.

b. Equilibrium in the money market, regardless of the equilibrium situation in the goods market.

c. Simultaneous equilibrium in both the goods and money markets.

d. Macroeconomic equilibrium, or equilibrium in all markets of the economy.

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Along the aggregate demand curve, each point represents:

a. Equilibrium in the goods market, regardless of the equilibrium situation in the money market.

b. Equilibrium in the money market, regardless of the equilibrium situation in the goods market.

c.c. Simultaneous equilibrium in both the goods and money Simultaneous equilibrium in both the goods and money markets.markets.

d. Macroeconomic equilibrium, or equilibrium in all markets of the economy.

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Shifts of the Aggregate Demand 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.

FIGURE 27.7 The Effect of an Increase in Money Supply on the AD Curve

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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.

FIGURE 27.8 The Effect of an Increase in Government Purchases or a Decrease in Net Taxes on the AD Curve

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FIGURE 27.9 Factors That Shift the Aggregate Demand Curve

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Which of the following policy mixes consistently shifts the aggregate demand curve to the right?

a. Expansionary monetary policy accompanied by contractionary fiscal policy.

b. Contractionary monetary policy accompanied by contractionary fiscal policy.

c. Contractionary monetary policy accompanied by expansionary fiscal policy.

d. Expansionary monetary policy accompanied by expansionary fiscal policy.

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Which of the following policy mixes consistently shifts the aggregate demand curve to the right?

a. Expansionary monetary policy accompanied by contractionary fiscal policy.

b. Contractionary monetary policy accompanied by contractionary fiscal policy.

c. Contractionary monetary policy accompanied by expansionary fiscal policy.

d.d. Expansionary monetary policy accompanied by Expansionary monetary policy accompanied by expansionary fiscal policy.expansionary fiscal policy.

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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

REVIEW TERMS AND CONCEPTS

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THE IS-LM DIAGRAM

A P P E N D I X A

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.

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.

FIGURE 27A.1 The IS Curve

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THE IS-LM DIAGRAM

A P P E N D I X A

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.

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.

FIGURE 27A.2 The LM Curve

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THE IS-LM DIAGRAM

A P P E N D I X A

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.

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.

FIGURE 27A.3 The IS-LM Diagram

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THE IS-LM DIAGRAM

A P P E N D I X A

THE IS-LM DIAGRAM

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

This increases the equilibrium value of both Y and r.

FIGURE 27A.4 An Increase in Government Purchases (G)

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THE IS-LM DIAGRAM

A P P E N D I X A

THE IS-LM DIAGRAM

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

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

FIGURE 27A.5 An Increase in the Money Supply (Ms)

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CHAPTER 27 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case,