PowerPoint Lectures for Principles of Macroeconomics, 9e By Karl E. Case, Ray C. Fair & Sharon M. Oster. ; ;. Aggregate Demand in the Goods and Money Markets. Prepared by:. Fernando & Yvonn Quijano. Aggregate Demand in the Goods and Money Markets. - PowerPoint PPT Presentation
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The Aggregate Demand (AD) CurveThe Aggregate Demand Curve: A WarningOther Reasons for a Downward-Sloping Aggregate Demand CurveAggregate Expenditure and Aggregate DemandShifts of the Aggregate Demand Curve
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.
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.
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.
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:
Expansionary Fiscal Policy: An Increase in Government Purchases (G) or a Decrease in Net Taxes (T)
An increase in government spending G from G0 to G1 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.
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.
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.
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.
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).
An increase in the money supply (Ms) causes the aggregate demand curve to shift to the right, from AD0 to AD1. 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
An increase in government purchases (G) or a decrease in net taxes (T) causes the aggregate demand curve to shift to the right, from AD0 to AD1. 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
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 IS0 to IS1.
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 (Ms) increases shift the LM curve to the right, from LM0 to LM1.
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 Y0 and r0.