Macro Chapter 27-Aggregate Demand

Aggregate
Demand in the
Goods and Money
Markets
CHAPTER OUTLINE
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:

The IS-LM Model
PART V The Core of Macroeconomic Theory
Policy Effects in the Goods and Money Markets
2012 Pearson Education
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
Shifts of the Aggregate Demand Curve from Policy Variables
Looking Ahead: Determining the Price Level

Appendix: The IS-LM Model
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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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FIGURE 27.1 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.
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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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E C O N O M I C S I N PR AC T I C E
Small Business and the Credit Crunch
We know how a firms

investment decisions
depend on the
interest rate.
In the recession of
20082009 some
firmsespecially
small oneswere
discouraged from
investing, not by high
interest rates, but by
the general
unwillingness of
banks to lend them
money at all.
Bailout Missed Main Street, New Report Says

The Wall Street Journal
5 of 39

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.
That is,
AE C + I + G
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FIGURE 27.2 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.
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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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Using a convenient shorthand:
r I AE Y
r I AE Y
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Equilibrium in Both the Goods and Money Markets: The IS-LM Model
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) increases, 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 r
d
Y M r
d
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Equilibrium in Both the Goods and Money Markets: The

IS-LM Model
FIGURE 27.3 Links between the Goods Market

and the Money Market
Planned investment depends on the interest rate, and
money demand depends on aggregate output.
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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).
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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.
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Expansionary Fiscal Policy: An Increase in Government Purchases (G)
or a Decrease in Net Taxes (T)
FIGURE 27.4 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
to Education
3.
2012 2
Pearson
14 of 39

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
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Expansionary Monetary Policy: An Increase in the Money Supply
Effects of an expansionary monetary policy:
M r I Y M
s
r decreases less than if M did not increase
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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 r I
d
Y decreases less than if r did not decrease

17 of 39

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
r increases less than if M
did not decrease
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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
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
Key :
: Variable increases.
: Variable decreases.
? : Forces push the variable in different directions . Without additional informatio n, we cannot
specify which way the variable moves.
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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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FIGURE 27.5 The Impact of an Increase in the Price Level on the EconomyAssuming No Changes in G, T, and Ms
This figure shows that when P increases, Y decreases.
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FIGURE 27.6 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.
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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 curves

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).
The initial decrease in consumption (brought about by the increase
in the interest rate) contributes to the overall decrease in output.
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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.
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FIGURE 27.7 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.
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FIGURE 27.8 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.
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FIGURE 27.9 Factors That Shift the Aggregate

Demand Curve
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Looking Ahead: Determining the Price Level
Our discussion of aggregate output (income) and the

interest rate in the goods and money markets is now
complete. You should have a good understanding of how
the two markets work together.
The AD curve is a useful summary of this analysis in that
every point on the curve corresponds to equilibrium in both
the goods and money markets for the given value of the
price level.
We have not yet, however, determined the price level. This
is the task of the next chapter.
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R E V I E W TE R M S AN D C O N C E PTS
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 39
CHAPTER 27 APPENDIX
The IS-LM Model
The IS Curve
FIGURE 27A.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.
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CHAPTER 27 APPENDIX
The IS-LM Model
The LM Curve
FIGURE 27A.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.
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CHAPTER 27 APPENDIX
The IS-LM Model
The IS-LM Diagram
FIGURE 27A.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.
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CHAPTER 27 APPENDIX
The IS-LM Model
The IS-LM Diagram
FIGURE 27A.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.
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CHAPTER 27 APPENDIX
The IS-LM Model
The IS-LM Diagram
FIGURE 27A.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.
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CHAPTER 27 APPENDIX
The IS-LM Model
The IS-LM Diagram
The IS-LM diagram is a useful way of seeing the effects of changes in

monetary and fiscal policies on equilibrium aggregate output (income) and
the interest rate through shifts in the two curves.
Always keep in mind the economic theory that lies behind the two curves.
Do not memorize what curve shifts when; be able to understand and
explain why the curves shift.
This means going back to the behavior of households and firms in the
goods and money markets.
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AP P E N D I X R E V I E W TE R M S AN D C O
NCEPTS
IS curve A curve illustrating the

negative relationship between the
equilibrium value of aggregate output
(income) (Y) and the interest rate in
the goods market.
LM curve A curve illustrating the

positive relationship between the
equilibrium value of the interest rate
and aggregate output (income) (Y) in
the money market.
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Macro Chapter 27-Aggregate Demand

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Aggregate

Equilibrium in Both the Goods and Money Markets:

PART V The Core of Macroeconomic Theory

Policy Effects in the Goods and Money Markets

2012 Pearson Education

Expansionary Policy Effects

The Aggregate Demand (AD) Curve

Looking Ahead: Determining the Price Level

PART V The Core of Macroeconomic Theory

goods market The market in which goods and

2012 Pearson Education

PART V The Core of Macroeconomic Theory

Planned Investment and the Interest Rate

FIGURE 27.1 Planned Investment Schedule

Planned investment spending is a negative function of the interest rate.

2012 Pearson Education

Planned Investment and the Interest Rate

PART V The Core of Macroeconomic Theory

In practice, the decision of a firm on how much to invest

2012 Pearson Education

PART V The Core of Macroeconomic Theory

We know how a firms

2012 Pearson Education

Bailout Missed Main Street, New Report Says

Planned Investment and the Interest Rate

PART V The Core of Macroeconomic Theory

We can use the fact that planned investment

2012 Pearson Education

Planned Investment and the Interest Rate

PART V The Core of Macroeconomic Theory

Planned Aggregate Expenditure and the Interest Rate

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

aggregate expenditure and thus reduces equilibrium income from Y0 to Y1.

2012 Pearson Education

Planned Investment and the Interest Rate

The effects of a change in the interest rate include:

PART V The Core of Macroeconomic Theory

Planned investment is a part of planned aggregate

2012 Pearson Education

Planned Investment and the Interest Rate

Planned Aggregate Expenditure and the Interest Rate

PART V The Core of Macroeconomic Theory

2012 Pearson Education

An increase in the interest rate (r) decreases output (Y) in

PART V The Core of Macroeconomic Theory

When income (Y) increases, this shifts the money demand

2012 Pearson Education

PART V The Core of Macroeconomic Theory

Equilibrium in Both the Goods and Money Markets: The

FIGURE 27.3 Links between the Goods Market

2012 Pearson Education

Policy Effects in the Goods and Money Markets

PART V The Core of Macroeconomic Theory

expansionary fiscal policy An increase in

2012 Pearson Education

expansionary monetary policy An

Policy Effects in the Goods and Money Markets

PART V The Core of Macroeconomic Theory

Expansionary Fiscal Policy: An Increase in

2012 Pearson Education

Policy Effects in the Goods and Money Markets

PART V The Core of Macroeconomic Theory

Policy Effects in the Goods and Money Markets

PART V The Core of Macroeconomic Theory