1 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Prepared by: Fernando Quijano & Shelly Tefft CASE FAIR OSTER P R I N C I P L E S O F MACROECONOMICS T E N T H E D I T I O N

2 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall

3 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall CHAPTER OUTLINE 12 Aggregate Demand in the Goods and Money Markets 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 Looking Ahead: Determining the Price Level Appendix: The IS-LM Model

4 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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.

5 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 I 0 to I 1.  FIGURE 12.1 Planned Investment Schedule Planned Investment and the Interest Rate

6 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 Investment and the Interest Rate Other Determinants of Planned Investment

7 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall We know how a firm’s investment decisions depend on the interest rate. In the recession of 2008–2009 some firms—especially small ones—were discouraged from investing, not by high interest rates, but by the general unwillingness of banks to lend them money at all. Small Business and the Credit Crunch E C O N O M I C S I N P R A C T I C E Bailout Missed Main Street, New Report Says The Wall Street Journal

8 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 Investment and the Interest Rate Planned Aggregate Expenditure and the Interest Rate

9 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall An increase in the interest rate from 3 percent to 6 percent lowers planned aggregate expenditure and thus reduces equilibrium income from Y 0 to Y 1.  FIGURE 12.2 The Effect of an Interest Rate Increase on Planned Aggregate Expenditure Planned Investment and the Interest Rate Planned Aggregate Expenditure and the Interest Rate

10 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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. Planned Investment and the Interest Rate Planned Aggregate Expenditure and the Interest Rate

11 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Using a convenient shorthand: Planned Investment and the Interest Rate Planned Aggregate Expenditure and the Interest Rate

12 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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: Equilibrium in Both the Goods and Money Markets: The IS-LM Model

13 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Planned investment depends on the interest rate, and money demand depends on aggregate output.  FIGURE 12.3 Links between the Goods Market and the Money Market Equilibrium in Both the Goods and Money Markets: The IS-LM Model

14 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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). Policy Effects in the Goods and Money Markets Expansionary Policy Effects

15 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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) Policy Effects in the Goods and Money Markets Expansionary Policy Effects

16 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall An increase in government spending G from G 0 to G 1 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 12.4 The Crowding-Out Effect Expansionary Fiscal Policy: An Increase in Government Purchases (G) or a Decrease in Net Taxes (T) Policy Effects in the Goods and Money Markets Expansionary Policy Effects

17 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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: Expansionary Fiscal Policy: An Increase in Government Purchases (G) or a Decrease in Net Taxes (T) Policy Effects in the Goods and Money Markets Expansionary Policy Effects

18 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Effects of an expansionary monetary policy: Expansionary Monetary Policy: An Increase in the Money Supply Policy Effects in the Goods and Money Markets Expansionary Policy Effects

19 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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: Contractionary Fiscal Policy: A Decrease in Government Spending (G) or an Increase in Net Taxes (T) Policy Effects in the Goods and Money Markets Contractionary Policy Effects

20 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall contractionary monetary policy A decrease in the money supply aimed at decreasing aggregate output (income) (Y). Effects of a contractionary monetary policy: Policy Effects in the Goods and Money Markets Contractionary Policy Effects Contractionary Monetary Policy: A Decrease in the Money Supply

21 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 Monetary Policy Policy Effects in the Goods and Money Markets The Macroeconomic Policy Mix

22 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 (AD) Curve

23 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall This figure shows that when P increases, Y decreases.  FIGURE 12.5 The Impact of an Increase in the Price Level on the Economy—Assuming No Changes in G, T, and M s The Aggregate Demand (AD) Curve

24 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall At all points along the AD curve, both the goods market and the money market are in equilibrium. The policy variables G, T, and M s are fixed.  FIGURE 12.6 The Aggregate Demand (AD) Curve The Aggregate Demand (AD) Curve

25 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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. The Aggregate Demand (AD) Curve The Aggregate Demand Curve: A Warning

26 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 Consumption Link The Aggregate Demand (AD) Curve

27 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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. Other Reasons for a Downward-Sloping Aggregate Demand Curve The Real Wealth Effect The Aggregate Demand (AD) Curve

28 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall An increase in the money supply (M s ) causes the aggregate demand curve to shift to the right, from AD 0 to AD 1. This shift occurs because the increase in M s 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 12.7 The Effect of an Increase in Money Supply on the AD Curve Shifts of the Aggregate Demand Curve from Policy Variables The Aggregate Demand (AD) Curve

29 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall An increase in government purchases (G) or a decrease in net taxes (T) causes the aggregate demand curve to shift to the right, from AD 0 to AD 1. 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 12.8 The Effect of an Increase in Government Purchases or a Decrease in Net Taxes on the AD Curve Shifts of the Aggregate Demand Curve from Policy Variables The Aggregate Demand (AD) Curve

30 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall  FIGURE 12.9 Factors That Shift the Aggregate Demand Curve Shifts of the Aggregate Demand Curve from Policy Variables The Aggregate Demand (AD) Curve

31 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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.

32 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 R E V I E W T E R M S A N D C O N C E P T S

33 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 IS 0 to IS 1.  FIGURE 12A.1 The IS Curve CHAPTER 12 APPENDIX The IS-LM Model The IS Curve

34 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 (M s ) increases shift the LM curve to the right, from LM 0 to LM 1.  FIGURE 12A.2 The LM Curve CHAPTER 12 APPENDIX The IS-LM Model The LM Curve

35 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 Y 0 and r 0.  FIGURE 12A.3 The IS-LM Diagram CHAPTER 12 APPENDIX The IS-LM Model The IS-LM Diagram

36 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall When G increases, the IS curve shifts to the right. This increases the equilibrium value of both Y and r.  FIGURE 12A.4 An Increase in Government Purchases (G) CHAPTER 12 APPENDIX The IS-LM Model The IS-LM Diagram

37 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall When M s increases, the LM curve shifts to the right. This increases the equilibrium value of Y and decreases the equilibrium value of r.  FIGURE 12A.5 An Increase in the Money Supply (M s ) CHAPTER 12 APPENDIX The IS-LM Model The IS-LM Diagram

38 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall CHAPTER 12 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.

39 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall A P P E N D I X R E V I E W T E R M S A N D C O N C E P T S 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.