IMPORTANT everything in this chapter for the most part relates back to the fact that planned investment and interest rates are negatively related This chapter just repeats itself based on this relationship Planned Investment and the Interest Rate When the interest rate rises it becomes more expensive to borrow causing fewer projects to take place The higher the interest rate the lower the level of planned investment Other Determinants of Planned Investment Planned investment also is determined by expectations of future sales not just interest rate Animal spirit the feelings entrepreneurs have about future sales Planned Aggregate Expenditure and the Interest Rate A change in the interest rate will lead to a change in AE When interest rate increases the AE curve shifts downward planned investment falls and output income Y falls by MORE than the fall in planned investment To sum up o High interest rates low planned investment o Since investment is a part of AE when the interest rates rise AE falls o A decrease in AE lowers output income Y by a multiple of the initial decrease in planned investment Short cuts to above info o R I AE Y o R I AE Y Equilibrium in Both the Goods and Money Markets The IS LM Model When output income increases this shifts the money demand curve to the right which increases the interest rate o Y Md r o Y Md r 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 all aimed at increasing output income Y o G or T o When G increases firms raise output income Y which increases demand for money This causes interest rates to rise Basically an increase in G increases both Y and r G Y r o However the increase in r because of the increase in G causes planned investment to decrease which works against the increase in G o Crowding out effect the last bullet point the tendency for increases in government spending to cause reductions in private investment o Summarization G Y Md r I Y increases LESS than if r did not increase Expansionary MONETARY policy an increase in the money supply aimed at o o Ms increasing output income Y Factors for the crowding out effect o If Fed expanded money supply before we assumed that the money supply was constant the gov spending multiplier would be larger This would cause the interest rates to stay constant so there would be no crowding out effect o Other things factor into planned investment not just interest rate so if these things allow planned investment to not fall when the interest rates rise there will be no crowding out effect Expansionary Monetary Policy An Increase in the Money Supply Open market operations inject new reserves into the system and expand the quantity of money supplied o This causes interest rates to fall because there s more money in circulation than households want to hold An increase in the money supply decreases the interest rate therefore increasing output income Y See summary of effects above to understand why this occurs o However the increase in Y also increases the demand for money which keeps the interest rate from falling Summarization o Ms r I Y Md o R decreases LESS than if Md did not increase Contractionary Policy Effects Contractionary FISCAL policy a decrease in government spending or an increase in net taxes aimed at decreasing output income Y o G or T These policies lead to a decrease in the demand for money and a decrease in the interest rate which leads to an increase in planned investment o G or T Y Md r I o Y decreases LESS than if r did not decrease Contractionary Monetary Policy A Decrease in the Money Supply Contractionary MONETARY policy a decrease in the money supply aimed at decreasing output income Y o A decrease in the money supply increases the interest rate which then obviously decreases investment This decrease decreases output income Y o The lower output income Y results in a decrease in the demand for money Summarization o Ms r I Y Md o R increases LESS than if Md did not decrease The Macroeconomic Policy Mix Policy mix the combination of monetary and fiscal policies in use at a given o Example if the government wanted to increase Y without changing r it could do so by increasing G and Ms time Ex pansionary fiscal and contractionary monetary this increases interest rate and decreases planned investment Expansionary monetary and contractionary fiscal this decreases interest rate and increases planned investment Expansionary monetary and fiscal this increases output income Y and increases consumption Contractionary monetary and fiscal this decreases output income Y and decreases consumption The Aggregate Demand AD Curve An increase in Y with P fixed shifts the money demand curve to the right which increases the interest rate o What happens if P changes If P increases it works exactly like an increase in Y by shifting the money demand curve to the right which therefore increases the interest rate o Opposite remains true This increased interest rate leads to a fall in investment which results in a Aggregate demand curve the negative relationship between the price level o Each point is when the goods market and the money market are in decrease in Y and output income Y equilibrium In addition aggregate demand falls when the price level increases because the higher price level causes the demand for money to rise Other Reasons for a Downward Sloping Aggregate Demand Curve The consumption link the initial decrease in consumption brought about by an increase in the interest rate contributes to the overall decrease in output income Y o To reiterate consumption works exactly like planned investment Both consumption and planned investment are negatively related to the interest rate The real wealth effect the change in consumption brought about by a change in real wealth which results from a change in the price level o When P increases output income Y decreases which decreases wealth o P and Y are negatively related to each other Shifts of the Aggregate Demand Curve From Policy Variables An increase in the money supply causes the AD curve to shift to the right o This occurs because the increase in the money supply lowers the interest rate which increases planned investment which then increases AE This results in an increase in output at every price level o Ms r I AE AD A decrease in the money supply contractionary monetary a decrease in government spending and an increase in net taxes
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