1. 1 of 37 Lecture 8 Planned Investment and the Interest RateOther Determinants of Planned InvestmentPlanned Aggregate Expenditure and the Interest Rate Equilibrium in Both the Goods and Money MarketsPolicy Effects in the Goods and Money MarketsExpansionary 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 Curve Aggregate Demand in the Goods and Money Markets

2. 2 of 37 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. 3 of 37 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. 4 of 37 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. 5 of 37 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. 6 of 37 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.  FIGURE 12.2 The Effect of an Interest Rate Increase on Planned Aggregate Expenditure

7. 7 of 37 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. 8 of 37 Planned Investment and the Interest Rate Planned Aggregate Expenditure and the Interest Rate Using a convenient shorthand:

9. 9 of 37 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. 10 of 37 Equilibrium in Both the Goods and Money Markets 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

11. 11 of 37 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. 12 of 37 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. Expansionary Fiscal Policy: An Increase in Government Purchases (G) or a Decrease in Net Taxes (T)

13. 13 of 37 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

14. 14 of 37 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. 15 of 37 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. 16 of 37 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. 17 of 37 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. 18 of 37 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

19. 19 of 37 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. 20 of 37 The Aggregate Demand (AD) Curve 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

21. 21 of 37 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

22. 22 of 37 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. 23 of 37 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. 24 of 37 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. 25 of 37 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. 26 of 37 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. 27 of 37 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

28. 28 of 37 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

29. 29 of 37 The Aggregate Demand (AD) Curve Shifts of the Aggregate Demand Curve  FIGURE 12.9 Factors That Shift the Aggregate Demand Curve

30. 30 of 37 aggregate demand 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 REVIEW TERMS AND CONCEPTS

31. 31 of 37 THE IS-LM DIAGRAM A P P E N D I X A THE IS CURVE An IS curve illustrates the negative relationship between the equilibrium value of aggregate output (income) (Y) and the interest rate in the goods market. 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

32. 32 of 37 THE IS-LM DIAGRAM A P P E N D I X A THE LM CURVE An LM curve illustrates the positive relationship between the equilibrium value of the interest rate and aggregate output (income) (Y) in the money market. 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

33. 33 of 37 THE IS-LM DIAGRAM A P P E N D I X A THE IS-LM DIAGRAM The IS-LM diagram is a way of depicting graphically the determination of aggregate output (income) and the interest rate in the goods and money markets. 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

34. 34 of 37 THE IS-LM DIAGRAM A P P E N D I X A THE IS-LM DIAGRAM 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)

35. 35 of 37 THE IS-LM DIAGRAM A P P E N D I X A THE IS-LM DIAGRAM 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 )