Equilibrium in Both the Goods and Money Markets: The IS-LM Model 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 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 Shifts of the Aggregate Demand Curve from Policy Variables 27

goods market money 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.

The links between goods and money markets: The money market determines the interest rate. The demand for money in the money market is affected by income (which is determined in the goods market). The goods market determines income, which depends on planned investment. Planned investment in turn depends on the interest rate (which is determined in the money market). The key link between the two markets is the interest rate…

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.

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.

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. That is, AE ≡ C + I + G

Planned Aggregate Expenditure and the Interest Rate An increase in the interest rate from 3 % to 6 % lowers planned aggregate expenditure and thus reduces equilibrium income from Y0 to Y1

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.

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 interest rate 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.

Equilibrium in Both the Goods and Money Markets: The IS-LM Model Planned investment depends on the interest rate, and money demand depends on aggregate output.

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. 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.

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. 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.

The IS-LM Model The IS-LM Diagram Equilibrium in the goods market (IS). Equilibrium in financial markets (LM). When the IS curve intersects the LM curve, both goods and financial markets are in equilibrium.

The IS-LM Model 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.

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.

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.

Expansionary Policy Effects: 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). Contractionary Policy Effects: contractionary fiscal policy - A decrease in government spending or an increase 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).

Expansionary Fiscal Policy: An Increase in Government Purchases (G) or a Decrease in Net Taxes (T) 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. 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) Effects of an expansionary fiscal policy:

Expansionary Monetary Policy: An Increase in the Money Supply Effects of an expansionary monetary policy:

Contractionary Policy Contractionary Fiscal Policy: A Decrease in Government Spending (G) or an Increase in Net Taxes (T) Contractionary Monetary Policy: A Decrease in the Money Supply Effects of a contractionary fiscal policy: Effects of a contractionary monetary policy:

The Macroeconomic Policy Mix The combination of monetary and fiscal policies in use at a given time.

The Aggregate Demand (AD) Curve The Impact of an Increase in the Price Level on the Economy — Assuming No Changes in G, T, and Ms

The Aggregate Demand (AD) Curve 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.

The Aggregate Demand 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.

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.

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). The initial decrease in consumption (brought about by the increase in the interest rate) contributes to the overall decrease in output.

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.

Shifts of the Aggregate Demand Curve from Policy Variables 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.

Shifts of the Aggregate Demand Curve from Policy Variables 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.

Shifts of the Aggregate Demand Curve from Policy Variables Factors That Shift the Aggregate Demand Curve: