Aggregate Demand in Goods and Money Market

Lectures 5-6, specification of the equilibrium level of aggregate output (income) in the market for goods and services

Lecture 7, equilibrium level of interest rate in the money market

Combine the goods and money markets, due to the strong correlation between those two

 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.

 There are two key links between the goods market and the money market: Link 1: Income and the Demand for Money Link 2: Planned Investment Spending and the Interest Rate

 Link 2 : Investment and the Interest Rate

Investment: purchase of new capital Cost of Investment: Nominal Cost + Interest Cost Building a new plant Requires money, which will be borrowed from a bank Real cost of investment depends on the interest rate Negative relationship between desired investment level and the interest rate

When the interest rate falls, planned investment rises. When the interest rate rises, planned investment falls.

 How does the interest rate affect the planned AE through Link 2?

AE = C + I+G A change in the investment level due to a change in the interest rate will change planned AE Given the change in AE, equilibrium income (output ) will change AE = Y

An increase in the interest rate level: 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.

r I AE Y r I AE Y

 Link 1 : Income and the Demand for Money

An increase in income shifts the money demand to the right With an increase in the money demand interest rate increases due to the fixed money supply

A decrease in income shifts the money demand to the left With a decrease in the money demand interest rate decreases due to the fixed money supply

Y M d r Y M r
d

 Given the links between the goods and money markets, we will check the effects of changes in fiscal and monetary policy actions on the economy

1) 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).

 Expansionary Fiscal Policy An increase in G With a given Y, AE>Y Firms stocks will be smaller than planned Unplanned inventory reductions will stimulate production Output level (Y) will increase With an increase in Y, Consumption C will increase, AE>Y The economy will turn to the step 3, and output will increase further This is nothing but the multiplier story, one unit increase in G creates more than one unit increase in equilibrium level of income

 Expansionary Fiscal Policy (Planned Investment depends on the interest rate) An increase in G With a given Y, AE>Y Firms stocks will be smaller than planned Unplanned inventory reductions will stimulate production Output level (Y) will increase, Md will increase, creating an increase in the interest rate An increase in r will decrease I; G increases, I decreases, C increases AE will increase but this time the increase in AE will be smaller than that of the previous case, AE>Y The economy will turn to the step 3, and output will increase further At the end, some part of the increase in G is offset by the decrease in I, so the multiplier effect of the increase in G is smaller.

 This effect of the planned investment is called as crowding-out effect.

Crowding-out Effect: The tendency for increases in government spending to cause reductions in private investment spending.

See the crowding-out effect on the graph

The Crowding-Out Effect

Effects of an expansionary fiscal policy:

G Y M d r I

 Expansionary Monetary Policy An increase in Money Supply, Ms With an increase in Ms, the equilibrium interest rate (r) will fall A decrease in r results in an increase in I An increase in I will increase AE, AE>Y Unplanned inventory reductions will stimulate production Output level (Y) will increase With an increase in Y, money demand, Md , will increase So, with an increase in money demand, the interest rate will decrease, which will decrease I

Effects of an expansionary monetary policy:

M s r I Y M d

2) Contractionary Policy Effects

contractionary fiscal policy A decrease in government spending or a reduction in net taxes aimed at decreasing aggregate output (income) (Y). contractionary monetary policy A decrease in the money supply aimed at decreasing aggregate output (income) (Y).

 contractionary fiscal policy

G Y M d r I
contractionary monetary policy

M s r I Y M d

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 ( G or T )
Expansiona ry ( M s )
Monetary Policy

Contractio nary ( G or T )
Y ?, r , I , C ?

Y , r ?, I ?, C

Contractio nary ( M s )
Key : : Variable increases. : Variable decreases.

Y ?, r , I , C ?

Y , r ?, I ?, C

? : Forces push the variable in different directions. Without additional information, we cannot specify which way the variable moves.

Aggregate Demand (AD)

aggregate demand The total demand for goods and services in the economy. Shows the equilibrium levels of aggregate output with different price levels in the economy. AD is derived under the assumption that fiscal policy variables, Government expenditures, taxes and monetary policy variables Money supply remain unchanged

DERIVING THE AGGREGATE DEMAND CURVE

The Impact of an Increase in the Price Level on the EconomyAssuming No Changes in G, T, and Ms

DERIVING THE AGGREGATE DEMAND CURVE aggregate demand curve (AD) 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.

An increase in the price level causes the level of aggregate output (income) to fall. A decrease in the price level causes the level of aggregate output (income) to rise. Each pair of P and Y on the AD corresponds to a point at which both the goods and the money markets are in equilibrium.

Important

AD is not a market demand curve aggregate demand Simple demand curve derived under the ceteris paribus assumption Other prices and income constant Change in the price of a specific product and change in the overall price level are different things. A change in the overall price level refers to the change in all prices

How does planned AE relate to AD?

AE = C + I+G Equilibrium Condition: AE = Y At ever point along AD equilibrium is achieved, AE = Y

At every point along the aggregate demand curve, the aggregate quantity demanded is exactly equal to planned aggregate expenditure, C + I + G.

Changes in AD

Along the AD the variables assumed to be unchanged are Government expenditures Taxes Money Supply A change in one of these factors will change the AD curve

 An increase in Money Supply Interest rate will fall Planned Investment will increase Increase in equilibrium output level

 An increase in Government Expenditures AE will increase directly Creates an increase in the equilibrium output level (crowding-out effect?)

An decrease in Taxes Disposable income, hence, consumption will increase AE will increase Creates an increase in the equilibrium output level (crowding-out effect?)

Which of the following policy mixes consistently shifts the aggregate demand curve to the right? a) b) c) d) Expansionary monetary policy accompanied by contractionary fiscal policy. Contractionary monetary policy accompanied by contractionary fiscal policy. Contractionary monetary policy accompanied by expansionary fiscal policy. Expansionary monetary policy accompanied by expansionary fiscal policy.

Aggregate Supply Curve (AS) and The Equilibrium Price Level

aggregate supply (AS) curve shows the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level.

 equilibrium price level The price level at which the aggregate demand and aggregate supply curves intersect.

Monetary and Fiscal Policy Effects on the Equilibrium Price Level

An increase in AD, while AS remains unchanged An increase in the money supply (expansionary monetary policy) An increase in the government expenditures (expansionary fiscal policy) A decrease in taxes (expansionary fiscal policy)

Monetary and Fiscal Policy Effects on the Equilibrium Price Level

A decrease in AD, while AS remains unchanged An decrease in the money supply (contractionary monetary policy) A decrease in the government expenditures (contractionary fiscal policy) An increase in taxes (contractionary fiscal policy)

Questions 1) Other things the same, as the price level rises, the real value of a dollar a. rises, and interest rates rise. b. rises, and interest rates fall. c. falls, and interest rates rise. d. falls, and interest rates fall. 2) When the dollar appreciates, U.S. a. exports decrease, while imports increase. b. exports and imports decrease. c. exports and imports increase. d. exports increase, while imports decrease.

Questions 3) When taxes increase, consumption a. decreases as shown by a movement to the left along a given aggregate demand curve. b. decreases as shown by shifting aggregate demand to the left. c. increases as shown by shifting aggregate supply the left. d. None of the above is correct. 4) People will want to hold more money if the price level a. or the interest rate increases. b. or the interest rate decreases. c. increases or the interest rate decreases. d. decreases or the interest rate increases.

Questions 5) Suppose that there is a multiplier effect that is greater than one and that there are no crowding out effect. Which of the following would shift aggregate demand right by more than the increase in expenditures? a. an increase in government expenditures. b. an increase in net exports. c. an increase in investment spending. d. All of the above are correct.