Chapter 12 Aggregate Demand in the Goods and Money Market Key link between money market and goods market is the interest rate When the Fed changes the money supply and thus changes the interest rate this affects aggregate demand main components of aggregate demand that are affected are durable goods housing investment plant and equipment investment by firms Interest rate increases aggregate demand decreases Every point on the aggregate demand curve reflects equilibrium in both the goods and money markets for the given price level Planned Investment and the Interest Rate Planned investment is no longer fixed now depends on the interest rate Interest rate increases planned investment spending decreases this downward sloping curve is also called the marginal efficiency of investment curve Investment also depends on expectations of future sale Keynes used the phrase animal spirits to describe the feelings of entrepreneurs these feelings affect investment decisions Remember that AE C I G aggregate expenditure consumption planned investment government spending but now investment depends on interest rate r o A high interest rate r discourages planned investment I o Planned investment is a part of aggregate expenditure AE o Thus when the interest rate rises planned aggregate expenditure at every level of income falls o A decrease in planned aggregate expenditure lowers equilibrium output income Y by a multiple of the initial decrease in planned investment Equilibrium in Both the Goods and Money Markets The IS LM Model Income increase money demand curve shifts to the right increases increases interest rate Given the interest rate the equilibrium level of output can be determined from the goods market Given output the equilibrium interest rate can be determined from the money market Links between the goods market and money market o Planned investment depends on the interest rate o Money demand depends on aggregate output 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 income Y Expansionary monetary policy an increase in the money supply aimed at increasing aggregate output income Y Expansionary Fiscal Policy Increase in gov purchases by 10 billion firms inventories are smaller than planned unplanned inventory reductions stimulate production firms increase output added output added income consumption spending increases final equilibrium level of output is higher by a multiple of initial increase in gov spending HOWEVER now lets look at how planned investment depends on the interest rate o As aggregate output income Y increases an impact is felt in the money market this increase in income increases the demand for money this disequilibrium between quantity demanded and quantity supplied causes the interest rate to rise therefore the increase in G increases both Y and r o However this increase in r causes planned investment spending I to decrease the decrease in I works against the increase in G o Crowding out effect the tendency for increases in government spending to cause reductions in private investment spending o Note size of the crowding out effect and the ultimate size of the government spending multiplier depend on several things We assume that the Fed did not raise the money supply in response to the increase in G Sensitivity or insensitivity of planned investment planned investment is not only affected by interest rates so sometimes the interest rate will increase and planned investment won t fall o Overall government spending increases Y increases demand for money increases interest rate increases planned investment decreases Y increases less than if r did not increase Expansionary monetary policy Fed increases the supply of money quantity of money supplied is greater than the quantity of money demanded so interest rate falls and then planned investment spending increases increased planned investment spending means planned aggregate expenditure is now greater than aggregate output firms experience unplanned decreases in inventories and they raise output o Overall money supply increases interest rate decreases planned investment increases Y increases demand for money increases r decreases less than if demand for money did not increase o Monetary policy can only be effective if I reacts to the changes in r Contractionary fiscal policy a decrease in government spending or an increase in net taxes aimed at decreasing aggregate output income Y o Decrease in gov spending or increase in taxes leads to a decrease in aggregate output income Y decrease in the demand for money decrease in the interest rat planned investment increases Y decreases less than if r did not decrease Contractionary monetary policy a decrease in the money supply aimed at decreasing aggregate output income Y o Money supply decreases interest rate increases planned investment decreases income decrease money demand decreases r increases less than if money demand did not decrease Policy mix the combination of monetary and fiscal policies in use at a given time o Decrease in gov spending and increase in money supply favors private investment spending over government spending o Expansionary fiscal policy and contractionary monetary policy opposite The Aggregate Demand AD Curve 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 appoint at which both the goods market and the money market are in equilibrium P increases money demand curve shifts to the right increases the interest rate fall in planned investment lower Y P decreases money demand curve shifts to the left decreases in the interest rate increases planned investment higher Y Reasons for a downward sloping aggregate demand curve o AD curve is not a market demand curve and it is not the sum of all market demand curves in the economy o It is the higher interest rate that causes aggregate output to fall o The consumption link increase in price level increases the demand for money increase in the interest rate decrease in consumption decrease in income o Real wealth effect the change in consumption brought about by a change in real wealth that results from a change in the price level If stock prices and housing prices rise by the same as the overall price level the real value of stocks and housing will remain unchanged Money supply increases
View Full Document
Unlocking...