Lecture 8 Wth
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Transcript of 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
Unplanned inventory reductions will stimulate production
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
Unplanned inventory reductions will stimulate production
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.