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© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 12 PART III THE CORE OF MACROECONOMIC THEORY Aggregate Demand in the Goods and Money Markets Fernando & Yvonn Quijano Adapted from: CHAPTER OUTLINE Planned Investment and the Interest RateEquilibrium in Both the Goods and Money Markets Policy Effects in the Goods and Money Markets The Aggregate Demand ( AD ) Curve

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 2 of 31 In Chapters 8 & 9, we focused on the goods market, exploring how the equilibrium level of aggregate output (Y) is determined. Y = C + I + G In Chapters 10 & 11, we looked at the money market, examining how the equilibrium level of interest rate (r) is determined. M d = M s However, the goods and money markets do not operate independently. Events in one market have effects on the other. In this chapter, we will bring the two markets together, in so doing explaining the links between Y and r. We also derive the aggregate demand (AD) curve, which explores the relation between Y and the price level (P).

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 3 of 31 12.1 Planned Investment and the Interest Rate In Chapters 8 & 9, we assumed for simplicity, that planned investment is fixed. In practice, 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.

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 4 of 31 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: expectation of future sales capital utilization rates relative capital and labor costs productive technology

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 5 of 31 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: AE ≡ C + I + G A negative relationship exists between r and Y in the goods market.

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 6 of 31 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.

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 7 of 31 The effects of an increase in interest rate from 3% to 6% 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 Y by a multiple of the initial decrease in planned investment (investment multiplier). To recall, any changes to M d or M s in the money market will change the equilibrium interest rate r. However, the effect is not confined to the money market, but will spillover to the goods market via planned investment (I). Eventually, equilibrium output Y will be affected.

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 8 of 31 12.2 Equilibrium in Both the Goods and Money Markets However, when income (Y) increases, it affects the equilibrium in the money market. That is, the money demand curve shifts to the right, which increases the interest rate (r) with a fixed money supply. We can thus write: A positive relationship exists between r and Y in the money market.

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 9 of 31 In the goods market, for a given value of r, we can determine the equilibrium value of Y (because I depends on r). In the money market, for a given value of Y, we can determine the equilibrium value of r (because money demand depends on Y). How do we find the one pair of Y and r that achieves overall equilibrium in both the goods and money markets? (We will use the IS-LM curves)

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 10 of 31 In the goods market: When r , Y When r , Y Each point on the IS curve represents the equilibrium point in the goods market for a given r. The IS Curve There exists a negative relationship between the equilibrium value of Y and r (IS curve)

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 11 of 31 The LM Curve In the money market: When Y , r When Y , r There exists a positive relationship between the equilibrium value of r and Y (LM curve) Each point on the LM curve represents the equilibrium point in the money market for a given Y.

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 12 of 31 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 IS-LM Diagram The equilibrium values of aggregate output and the interest rate are Y 0 and r 0.

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 13 of 31 12.3 Expansionary Policy Effects in the Goods and Money Markets expansionary fiscal policy An increase in government spending or a reduction in net taxes aimed at increasing aggregate output (Y). expansionary monetary policy An increase in the money supply aimed at increasing aggregate output (Y). (1) Expansionary Fiscal Policy: An Increase in G or a Decrease in T Goods Market

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 14 of 31 Money Market Goods Market An expansionary fiscal policy tends to lead to a crowding-out effect. In this case, the reductions in private investment spending (I).

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 15 of 31 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.

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 16 of 31 The size of the crowding-out effect depends on: 1)The action of the central bank in the money market. If the central bank increases money supply simultaneously such that r remains unchanged, then there would be no crowding out effect. 2)The sensitivity of planned investment to changes in the interest rate. If the slope of the investment curve is very steep, then there is little change in I as a result of changes in r.

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 17 of 31 In the goods market, an increase in G will raise the equilibrium value of Y at the same level of r. This implies that the IS curve will shift to the right from IS 0 to IS 1. Graphical Depiction via IS-LM Diagram

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 18 of 31 So, when the government pursues an expansionary fiscal policy, the IS curve shifts to the right from IS 0 to IS 1. At the new equilibrium point, both the Y and r have increased. As noted earlier, if r did not increase, there will be no crowding-out effect, and Y will increase even more.

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 19 of 31 (2) Expansionary Monetary Policy: An Increase in M s Effects of an expansionary monetary policy: In the money market, an increase in M s will decrease the equilibrium value of r at the same level of Y. This implies that the LM curve will shift to the right from LM 0 to LM 1.

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 20 of 31 So, when the government pursues an expansionary monetary policy, the LM curve shifts to the right from LM 0 to LM 1. At the new equilibrium point, Y increases but r falls.

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 21 of 31 Effects of a contractionary fiscal policy: 12.4 Contractionary Policy Effects in the Goods and Money Markets (1) Contractionary Fiscal Policy: A Decrease in G or an Increase in T contractionary policies aimed at decreasing aggregate output (Y), often used to fight inflation. It will be clearer to use the IS-LM Diagram, where the IS curve shifts to the left. At the new equilibrium point, both Y and r decrease.

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 22 of 31 Effects of a contractionary monetary policy: (2) Contractionary Monetary Policy: A Decrease in M s It will be clearer to use the IS-LM Diagram, where the LM curve shifts to the left. At the new equilibrium point, Y decreases but r increases.

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 23 of 31 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 12.5 Macroeconomic Policy Mix Effects in the Goods and Money Markets It will be clearer to use the IS-LM Diagram

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 24 of 31 12.6 The Aggregate Demand (AD) Curve The AD curve shows the equilibrium levels of Y associated with different price levels (P) in the economy, taking into account the behavior of firms and households in both the goods and money markets at the same time. The AD curve is derived by assuming the government does not take any action (G, T or M s ) to affect the economy in response to changes in P. The AD curve shows the relation between the aggregate quantity of goods demanded (C + I + G) and the price level P. To derive the AD curve, we examine what happens to Y when P changes.

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 25 of 31 FIGURE 12.5 The Impact of an Increase in the Price Level on the Economy—Assuming No Changes in G, T, and M s

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 26 of 31 Each point on the AD curve is a point at which both the goods market and the money market are in equilibrium. From the slide, it is clear that: When P , Y When P , Y A negative relationship exists between P and Y.

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 27 of 31 Alternative: Deriving the AD curve using IS-LM framework For a given price level (P) the aggregate quantity of output demanded is determined where the IS and LM curves intersect. For instance, at P 0, the equilibrium point is at E, with the corresponding output at Y 0. When P to P 1, the LM curve shifts to the left due to a reduction in real money supply. At the new equilibrium point of F, the aggregate quantity of output demanded falls from Y 0 to Y 1. IS LM 0 (P = P 0 ) E LM 1 (P = P 1 ) F Y0Y0 Y1Y1 Y0Y0 Y r Y P Y1Y1 P0P0 AD E F

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 28 of 31 The Aggregate Demand (AD) Curve: A Warning The AD curve is more complex than a simple individual or market demand (DD) curve. The AD curve is not a market demand curve, and it is not the sum of all market demand curves in the economy. Even though both the AD and DD curves are download-sloping, the reasons behind are different. Why DD curve is downward-sloping? Substitution effect Income effect Why AD curve is downward-sloping? Interest rate link. An increase in the price level reduces the real money supply, and shifts the LM curve to the left. At the new equilibrium point, interest rate increases, which reduces the demand for goods by households and firms.

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 29 of 31 Other Reasons for a Downward-Sloping AD Curve (1) The Consumption Link Even though we have assumed that consumption (C) depends only on income (Y), in practice, interest rates also affect the level of C. i.e. when r , I and C at the same time So, when P , M d (shifts to the right), r , C (and I ), AE , Y The consumption link thus explains the negative relationship between P and Y. (2) The Real Wealth (or Real Balance) Effect When P , your real wealth (erosion in purchasing power), C , AE , Y

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 30 of 31 At a fixed level of P, if M s , r , I and C , AE , Y . Thus, the AD curve will shift to the right, from AD 0 to AD 1. The AD curve will shift if any of the policy variables (M s, G, T) change. 12.7 The Shifts in Aggregate Demand (AD) Curve

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 31 of 31 As for a decrease in T, C , AE , Y (again, there will be crowding- out effect from the interaction with money market). The AD curve will also shift to the right, from AD 0 to AD 1. At a fixed level of P, if G , AE , Y (though some of the increases will be crowded out due to a fall in interest rate in the money market). Thus, the AD curve will shift to the right, from AD 0 to AD 1.

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CHAPTER 12 Aggregate Demand in the Goods and Money Markets © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 32 of 31 Summary: Factors That Shift the AD Curve The aggregate demand is determined by the intersection of the IS and LM curves. Hence, holding the price level constant, any factor that causes the equilibrium point to shift will also move the AD curve in a similar direction. Please take note that the choice of IS-LM and AD-AS depends on the issue addressed. The IS-LM framework relates the interest rate to output; whereas the AD-AS relates the price level to output.

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