Chapter 11: Aggregate Demand II

Fiscal Policy Initial equilibrium: IS 1 = LM 1 with Y 1 and r 1 Let G increase and/or T decrease IS increases, resulting in Y 2 >Y 1 Crowding-out effect: As Y increases, demand for money rises, interest rate and income fall Final equilibrium: IS 2 = LM 1 with Y 3 >Y 2 and r 2 >r 1

Fiscal Policy LM 1 IS 2 IS 1 r2r2 r1r1 Y1Y1 Y3Y3 Y2Y2 Interest Rate Income

Monetary Policy Initial equilibrium: IS 1 = LM 1 with Y 1 and r 1 Let M increase at constant P LM increases, resulting in Y 2 >Y 1 and r 2 <r 1 Crowding-out effect won’t take place because while income rises, interest rate falls

Monetary Policy LM 1 LM 2 IS 1 r2r2 r1r1 Y1Y1 Y2 Interest Rate Income

Policy Reaction 1 Policy measure: concretionary fiscal FED’s Reaction: none Policy results: IS falls, reducing income and interest rate

Policy Reaction 1 LM 1 IS 1 IS 2 r1r1 r2r2 Y2Y2 Y1Y1 Interest Rate Income

Policy Reaction 2 Policy measure: concretionary fiscal Policy results: IS falls, reducing Y and r FED’s reaction: holding interest rate constant by decreasing the money supply, reducing Y and increasing r Policy results: sharp reduction in income at constant interest rate

Policy Interaction 2 LM 1 IS 1 IS 2 r1r1 r2r2 Y2Y2 Y1Y1 Interest Rate Income LM 2 Y3Y3

Policy Reaction 3 Policy measure: concretionary fiscal Policy results: IS falls, reducing Y and r FEDs reaction: holding income constant by increasing the money supply, reducing r and increasing Y Policy results: sharp reduction in interest rate at constant income

Policy Interaction 3 LM 1 IS 1 IS 2 r1r1 r3r3 Y2Y2 Y1Y1 Interest Rate Income LM 2 r2r2

Expectations Business outlook –Optimism: I and IS increase, resulting in higher Y but lower r –Pessimism: I and IS decrease, resulting in lower Y but higher r Consumer confidence –Optimism: C and IS increase, resulting in higher Y but lower r –Pessimism: C and IS decrease, resulting in lower Y but higher r

Identifying Aggregate Demand Initial equilibrium: IS 1 = LM 1 with Y 1 and r 1 Let P increase, causing M/P to decline LM decreases, resulting in Y 2 r 1 As Y falls, demand for goods and services declines, resulting in a higher price Lower Y, but higher P identifies the AD

Identifying Aggregate Demand LM 1 IS 2 r2r2 r1r1 Y1Y1 LM 2 Y2Y2 Income Interest Rate Income Price AD P2P2 P1P1 Y1Y1 Y2Y2 B A

Monetary Policy Initial equilibrium: IS 1 = LM 1 with Y 1 and r 1 Let M increase, causing M/P to rise LM increases, resulting in Y 2 >Y 1 and r 2 <r 1 Increased Y at constant P indicates an increase in AD

Monetary Policy LM 1 IS 2 r1r1 r2r2 Y2Y2 LM 2 Y1Y1 Income Interest Rate Income Price AD 1 P Y2Y2 Y1Y1 A B AD 2

Fiscal Policy Initial equilibrium: IS 1 = LM 1 with Y 1 and r 1 Let G increase, causing IS to rise An increase in IS result in Y 2 >Y 1 and r 2 >r 1 Increased Y at constant P indicates an increase in AD

Fiscal Policy LM 1 IS 1 r2r2 r1r1 Y2Y2 IS 2 Y1Y1 Income Interest Rate Income Price AD 1 P Y2Y2 Y1Y1 BA AD 2

Long-run Equilibrium Initial equilibrium: IS 1 = LM 1 with Y 1 and r 1, but Y 1 <Y indicates insufficient expenditures in the economy Insufficient AD results in a lower P, causing M/P to rise Both LM and SRAS increase, increasing Y 1 toward Y Long-run equilibrium is at the intersection of LRAS and AD

Increase in Aggregate Demand LM 1 IS 1 r2r2 r1r1 Y IS 2 Y1Y1 Income Interest Rate Income Price AD 1 P2P2 YY1Y1 AD 2 LRAS LM 2 P1P1 SRAS 1 SRAS 2

Reasons for The Great Depression Spending hypothesis: IS declined sharply –The Stock Market crash reduced consumer wealth and spending –Decline in immigration reduced the demand for residential investment –Business pessimism caused bank failure –The government increased the rate of income taxation

Reasons for The Great Depression Monetary hypothesis: LM declined sharply –Price deflation due to reduced Aggregate Demand –Tight monetary policy as the FED increased the discount rate to halt gold outflow –The fall in the real interest rate reduced the speculative demand for money