lecture 8 wth

8/4/2019 Lecture 8 Wth

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Aggregate Demand in Goods and Money Market

1

Lectures 5-6, specification of the equilibrium level of aggregate output

(income) in the market for goods and services

Lecture 7, equilibrium level of interest rate in the money market

Combine the goods and money markets, due to the strong correlation

between those two


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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.


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There are two key links between the goods market and the money market:

Link 1: Income and the Demand for Money

Link 2: Planned Investment Spending and the Interest Rate


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Link 2 : Investment and the Interest Rate

Investment: purchase of new capital

Cost of Investment: Nominal Cost + Interest Cost

Building a new plant

Requires money, which will be borrowed from a bank

Real cost of investment depends on the interest rate

Negative relationship between desired investment level and the interest

rate


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When the interest rate falls,

planned investment rises.

When the interest rate rises,planned investment falls.


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How does the interest rate affect the planned AE through Link 2?

AE = C + I+G

A change in the investment level due to a change in the interest rate willchange planned AE

Given the change in AE, equilibrium income (output ) will change

AE = Y


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An increase in the interest rate level:

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.

YAEIr

YAEIr


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Link 1 : Income and the Demand for Money

An increase in income shifts the money demand to the right

With an increase in the money demand interest rate increases due to the

fixed money supply

A decrease in income shifts the money demand to the left

With a decrease in the money demand interest rate decreases due to the

fixed money supply

rMY

rMY

d

d


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Given the links between the goods and money markets, we will check theeffects of changes in fiscal and monetary policy actions on the economy

1) 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).


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Expansionary Fiscal Policy

An increase in G

With a given Y, AE>Y

Firms stocks will be smaller than planned

Unplanned inventory reductions will stimulate production

Output level (Y) will increase

With an increase in Y, Consumption C will increase, AE>Y

The economy will turn to the step 3, and output will increase further

This is nothing but the multiplier story, one unit increase in G creates

more than one unit increase in equilibrium level of income


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Expansionary Fiscal Policy (Planned Investment depends on the interest rate)

An increase in GWith a given Y, AE>Y

Firms stocks will be smaller than planned


Output level (Y) will increase, Md will increase, creating an increase in

the interest rate

An increase in r will decrease I; G increases, I decreases, C increases

AE will increase but this time the increase in AE will be smaller than

that of the previous case, AE>Y

The economy will turn to the step 3, and output will increase further

At the end, some part of the increase in G is offset by the decrease in

I, so the multiplier effect of the increase in G is smaller.


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This effect of the planned investment is called as crowding-out effect.

Crowding-out Effect: The tendency for increases in government spending

to cause reductions in private investment spending.

See the crowding-out effect on the graph


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The Crowding-Out Effect


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Effects of an expansionary fiscal policy:

dG Y M r I


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Expansionary Monetary Policy

An increase in Money Supply,Ms

With an increase in Ms, the equilibrium interest rate (r) will fall

A decrease in rresults in an increase inI

An increase inIwill increaseAE,AE>Y


Output level (Y) will increase

With an increase in Y, money demand,Md , will increase

So, with an increase in money demand, the interest rate will decrease,

which will decreaseI


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Effects of an expansionary monetary policy:

s d

M r I Y M


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2) Contractionary Policy Effects

contractionary fiscal policy A decrease in government

spending or a reduction in net taxes aimed at decreasing aggregate

output (income) (Y).

contractionary monetary policy A decrease in the money

supply aimed at decreasing aggregate output (income) (Y).


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contractionary fiscal policy

contractionary monetary policy

dG Y M r I

s d M r I Y M


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policy mix The combination of monetary and fiscal policies in use at

a given time.

THE MACROECONOMIC POLICY MIX

TABLE 12.1 The Effects of the Macroeconomic Policy Mix

FISCAL POLICY

Monetary

Policy

)or(

ryExpansiona

TG )or(

naryContractio

TG

)(

ryExpansionas

M

)(

naryContractios

M

CIrY ?,?,, ?,,?, CIrY

?,,?, CIrY CIrY ?,?,,

moves.variablethewaywhichspecify

cannotwen,informatioadditionalWithout.directionsdifferentinvariablethepushForces:?

decreases.Variable:

increases.Variable

:Key

:


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Aggregate Demand (AD)

aggregate demand The total demand for goods and services in the

economy.

Shows the equilibrium levels of aggregate output with different price

levels in the economy.

AD is derived under the assumption that

fiscal policy variables,

Government expenditures, taxes

and monetary policy variables

Money supply

remain unchanged


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The Impact of an Increase in the Price Level on the EconomyAssuming No Changes in G, T,

andMs

DERIVING THE AGGREGATE DEMAND CURVE


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aggregate demand curve (AD) 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 themoney market are in equilibrium.

DERIVING THE AGGREGATE DEMAND CURVE

An increase in the price level causes the level of aggregate output (income) to fall.

A decrease in the price level causes the level of aggregate output (income) to rise.

Each pair of P and Y on the AD corresponds to a point at which both the goods

and the mone markets are in e uilibrium.


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Important

AD is not a market demand curve aggregate demand

Simple demand curve derived under the ceteris paribus assumption

Other prices and income constant

Change in the price of a specific product and change in the overall price

level are different things.

A change in the overall price level refers to the change in all prices


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How does planned AE relate to AD?

AE = C + I+G

Equilibrium Condition:AE = Y

At ever point along AD equilibrium is achieved,AE = Y


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At every point along the aggregate

demand curve, the aggregate

quantity demanded is exactly equal

to planned aggregate expenditure, C+I+ G.


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Changes in AD

Along the AD the variables assumed to be unchanged are

Government expenditures

Taxes

Money Supply

A change in one of these factors will change the AD curve


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An increase in Money Supply

Interest rate will fall

Planned Investment will increase

Increase in equilibrium output level


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An increase in Government Expenditures

AE will increase directly

Creates an increase in the equilibrium output level (crowding-out

effect?)

An decrease in Taxes

Disposable income, hence, consumption will increase

AE will increase

Creates an increase in the equilibrium output level (crowding-out

effect?)


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Which of the following policy mixes consistently shifts the aggregate

demand curve to the right?

a) Expansionary monetary policy accompanied by contractionary

fiscal policy.

b) Contractionary monetary policy accompanied by contractionary

fiscal policy.

c) Contractionary monetary policy accompanied by expansionaryfiscal policy.

d) Expansionary monetary policy accompanied by expansionary

fiscal policy.


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Aggregate Supply Curve (AS) and The Equilibrium Price Level

aggregate supply (AS) curve shows the relationship between the

aggregate quantity of output supplied by all firms in an economy and the

overall price level.


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equilibrium price level The price level at which the aggregate demand

and aggregate supply curves intersect.


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Monetary and Fiscal Policy Effects on the Equilibrium Price Level

An increase in AD, while AS remains unchanged

An increase in the money supply (expansionary monetary

policy)

An increase in the government expenditures (expansionary

fiscal policy)

A decrease in taxes (expansionary fiscal policy)


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Monetary and Fiscal Policy Effects on the Equilibrium Price Level

A decrease in AD, while AS remains unchanged

An decrease in the money supply (contractionary monetary

policy)

A decrease in the government expenditures (contractionary

fiscal policy)

An increase in taxes (contractionary fiscal policy)


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Questions

1) Other things the same, as the price level rises, the real value of a

dollar

a. rises, and interest rates rise.

b. rises, and interest rates fall.

c. falls, and interest rates rise.d. falls, and interest rates fall.

2) When the dollar appreciates, U.S.

a. exports decrease, while imports increase.

b. exports and imports decrease.

c. exports and imports increase.

d. exports increase, while imports decrease.


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Questions

3) When taxes increase, consumption

a. decreases as shown by a movement to the left along a given

aggregate demand curve.

b. decreases as shown by shifting aggregate demand to the left.

c. increases as shown by shifting aggregate supply the left.d. None of the above is correct.

4) People will want to hold more money if the price level

a. or the interest rate increases.

b. or the interest rate decreases.

c. increases or the interest rate decreases.

d. decreases or the interest rate increases.


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Questions

5) Suppose that there is a multiplier effect that is greater than one and that

there are no crowding out effect. Which of the following would shift

aggregate demand right by more than the increase in expenditures?

a. an increase in government expenditures.

b. an increase in net exports.c. an increase in investment spending.

d. All of the above are correct.

lecture 8 wth

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