1. 12 10 th Edition Planned Investment and the Interest RateOther Determinants of Planned InvestmentPlanned Aggregate Expenditure and the Interest Rate Equilibrium in Both the Goods and Money Markets Policy Effects in the Goods and Money Markets Expansionary Policy EffectsContractionary Policy EffectsThe Macroeconomic Policy MixThe Aggregate Demand ( AD ) Curve The Aggregate Demand Curve: A WarningOther Reasons for a Downward-Sloping Aggregate Demand Curve Aggregate Expenditure and Aggregate DemandShifts of the Aggregate Demand CurveLooking Ahead: Determining the Price Level CHAPTER OUTLINE Aggregate Demand in the Goods and Money Markets

2. 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.

3. 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 I 0 to I 1.  FIGURE 12.1 Planned Investment Schedule

4. 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.

5. Increase in Planned Investment – Shift to the right I1I1 I2I2

6. Decrease in Planned Investment – Shift to the left I1I1 I2I2

7. Planned Investment and the Interest Rate Planned Aggregate Expenditure and the Interest Rate Recall that planned aggregate expenditure is the sum of consumption, planned investment, and government purchases. AE ≡ C + I + G 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. AE = C + I (r)+ G

8. Planned Investment and the Interest Rate An increase in the interest rate from 3 percent to 6 percent reduces planned investment from I 0 to I 1.

9. Planned Investment and the Interest Rate Planned Aggregate Expenditure and the Interest Rate 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.

10. 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 as on the previous slide, 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 – a multiplier effect.

11. Planned Investment and the Interest Rate Planned Aggregate Expenditure and the Interest Rate Using a convenient shorthand: An increase in the interest rate (r) decreases output (Y) in the goods market because an increase in r lowers planned investment.

12. Equilibrium in Both the Goods and Money Markets When income (Y) increase, this shifts the money demand curve to the right, which increases the interest rate (r) with a fixed money supply. We can thus write:

13. THE LINKS BETWEEN THE GOODS MARKET AND THE MONEY MARKET The Effect of an Increase in Income (Y) on the Interest Rate (r)

14. Equilibrium in Both the Goods and Money Markets The Money Market and the Goods Market Interact. Planned investment depends on the interest rate, and money demand depends on aggregate output. Links Between the Goods Market and the Money Market

15. 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). * Remember, a reduction in net taxes also occurs if transfer payments are increased.

16. Policy Effects in the Goods and Money Markets Expansionary Policy Effects crowding-out effect The tendency for increases in government spending to cause reductions in private investment spending. Question: what would cause this to occur? Expansionary Fiscal Policy: An Increase in Government Purchases (G), a Decrease in Taxes (T), or and increase in transfer payments

17. Policy Effects in the Goods and Money Markets Expansionary Policy Effects Expansionary Fiscal Policy: An Increase in Government Purchases (G) or a Decrease in Net Taxes (T) 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

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

19. 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.

20. More interest sensitivity, more crowding-out and fiscal policy is less effective. interest sensitivity or insensitivity of planned investment interest sensitive interest insensitive

21. Policy Effects in the Goods and Money Markets Expansionary Policy Effects Expansionary Monetary Policy: An Increase in the Money Supply Effects of an expansionary monetary policy: Monetary policy can be effective only if I reacts to changes in r. If I is interest sensitive, monetary policy is effective. If I is interest insensitive, monetary policy is not effective.

22. A closer look However, the increase in the demand for money keeps the interest rate from falling as far as it otherwise would. The interest rate does not fall from 6% to 3%, it falls from 6% to 5%. An increase in the money supply from M 0 to M 1 decreases the interest rate and increases investment and income.

23. Policy Effects in the Goods and Money Markets Contractionary Policy Effects Contractionary Fiscal Policy: A Decrease in Government Spending (G), an Increase in Taxes (T), or a decrease in transfer payments. Effects of a contractionary fiscal policy:

24. Policy Effects in the Goods and Money Markets Contractionary Policy Effects contractionary monetary policy A decrease in the money supply aimed at increasing r and decreasing aggregate output (income) (Y). Effects of a contractionary monetary policy:

25. Policy Effects in the Goods and Money Markets 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 Monetary Policy

26. The Aggregate Demand (AD) Curve aggregate demand The total demand for goods and services in the economy. 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.

27. The Aggregate Demand (AD) Curve This figure shows that when P increases, Y decreases. The Impact of an Increase in the Price Level on the Economy - Assuming No Changes in G, T, and M s

28. 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 M s are fixed.  FIGURE 12.6 The Aggregate Demand (AD) Curve

29. The Aggregate Demand (AD) Curve The Aggregate Demand Curve: A Warning It is important that you realize what the aggregate demand curve represents. The AD curve is a market equilibrium curve. 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.

30. The Aggregate Demand (AD) Curve 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 (r), 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.

31. The Aggregate Demand (AD) Curve 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.

32. Nominal and Real Wealth Nominal Wealth (W) = Assets – Liabilities Assets are things you own (e.g., stocks, bonds, house, car, savings account) Liabilities are things you owe (e.g., mortgage, car loan, students loan) Real Wealth = P= Price Level Two things change real wealth - W or P

33. As P ↑ => (W/P) ↓ => C ↓ => AE ↓ => Y ↓, and vice-versa C Y 45 0 Y1Y1 Y0Y0 A B AE 1 AE 0

34. The Aggregate Demand (AD) Curve Shifts of the Aggregate Demand Curve 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 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.  FIGURE 12.7 The Effect of an Increase in Money Supply on the AD Curve

35. The Aggregate Demand (AD) Curve Shifts of the Aggregate Demand 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 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

36. The Aggregate Demand (AD) Curve Factors that Shift the Aggregate Demand Curve

37. The Aggregate Demand (AD) Curve Shifts of the Aggregate Demand Curve An increase in Investment (I) or autonomous consumption (C) causes the aggregate demand curve to shift to the right, from AD 0 to AD 1. The increase in I or C increases planned aggregate expenditure, which leads to an increase in output at each possible price level. An increase in investment – the investment curve shits to the right. An increase in consumption – the consumption function shifts up. The Effect of an Increase in I or C on the AD Curve I ↑ or C ↑

38. 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.

39. 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