1. Aggregate Demand in the Goods and Money Markets
Prepared by:
Fernando & Yvonn Quijano

2. Aggregate Demand in the Goods and Money Markets
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
 FIGURE 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.

4. Planned Investment and the Interest Rate
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. Planned Investment and the Interest Rate
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.
AE ≡ C + I + G

6. Planned Investment and the Interest Rate
Planned Aggregate Expenditure and the Interest Rate
 FIGURE 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.

7. Planned Investment and the Interest Rate
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.

8. Planned Investment and the Interest Rate
Planned Aggregate Expenditure and the Interest Rate
Using a convenient shorthand:

9. Equilibrium in Both the Goods and Money Markets
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) 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:

10. Equilibrium in Both the Goods and Money Markets
 FIGURE Links Between the Goods Market and the Money Market
Planned investment depends on the interest rate, and money demand depends on aggregate output.

11. 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).

12. 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)
crowding-out effect The tendency for increases in government spending to cause reductions in private investment spending.

13. 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)
 FIGURE 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 2 to 3.

14. 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)
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:

15. 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:

16. Policy Effects in the Goods and Money Markets
Contractionary Policy Effects
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:

17. Policy Effects in the Goods and Money Markets
Contractionary Policy Effects
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:

18. 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 The Effects of the Macroeconomic Policy Mix
Fiscal Policy
Monetary Policy

19. 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.

20. The Aggregate Demand (AD) Curve
 FIGURE The Impact of an Increase in the Price Level on the Economy—Assuming No Changes in G, T, and Ms
This figure shows that when P increases, Y decreases.

21. The Aggregate Demand (AD) Curve
 FIGURE 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.

22. The Aggregate Demand (AD) Curve
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.

23. 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, which leads to a decrease in consumption (as well as planned investment), which leads to a decrease in aggregate output (income).

24. The Aggregate Demand (AD) Curve
Other Reasons for a Downward-Sloping Aggregate Demand Curve
The Consumption Link
The initial decrease in consumption (brought about by the increase in the interest rate) contributes to the overall decrease in output.
Planned investment does not bear all the burden of providing the link from a higher interest rate to a lower level of aggregate output.
Decreased consumption brought about by a higher interest rate also contributes to this effect.

25. 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.

26. equilibrium condition: C + I + G = Y
The Aggregate Demand (AD) Curve
Aggregate Expenditure and Aggregate Demand
At equilibrium, planned aggregate expenditure (AE ≡ C + I + G) and aggregate output (Y) are equal:
equilibrium condition: C + I + G = Y

27. The Aggregate Demand (AD) Curve
Shifts of the Aggregate Demand Curve
 FIGURE 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.

28. The Aggregate Demand (AD) Curve
Shifts of the Aggregate Demand Curve
 FIGURE 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.

29. The Aggregate Demand (AD) Curve
Shifts of the Aggregate Demand Curve
 FIGURE Factors That Shift the Aggregate Demand Curve