Download CHAPTER 24

COORDINATING ECONOMIC
ACTIVITY:
AGGREGATE DEMAND & SUPPLY
ECONOMIC FLUCTUATIONS
• Movements of GDP away
from potential output;
• Also referred to as business
cycles;
KEYNESIAN ECONOMICS
• Models based on the idea that
demand determines output in the
short run;
• Short run -- The period of time when
prices are fixed;
REAL SHOCKS TO THE ECONOMY
One cause of economic fluctuations :
• Developing countries dependent on agriculture,
which suffer loss to cash crop
• Sharp increases in the price of oil can hurt
modern economies
• Wars can devastate entire regions of the world
• Natural disasters can cause sharp reductions in
GDP
• Major shifts in technology leading to the birth of
new industries have profound effects on the
economy
REAL BUSINESS CYCLE THEORY
• School of economic thought that emphasizes the
role that shocks to technology can play in
causing economic fluctuations
• Led by Edward Prescott of the University of
Minnesota
• Developed models that integrate technology
shocks into classical models
• Changes in technology will usually change the
level of full employment or potential output
• It portrays economic fluctuations as movements
in potential output, not as deviations away from
potential output
INITIAL PATTERN OF DEMAND AND PRICES
Price
S
P0
D
Tennis Racquets
Q0
Quantity
INITIAL PATTERNS OF DEMAND AND PRICES
Price
Price
S
P0
S
P1
D
Tennis Racquets
Q0
Quantity Roller blades Q1
D
Quantity
DEMAND AND PRICES AFTER CHANGES IN TASTES
Price
Price
S
S
P1
PA
DB
DA
Tennis Racquets Q
A
D
Quantity Roller blades Q1
D
Quantity
Suppose rollerblading starts to replace tennis. Demand shifts to DA in the
market in tennis racquets and DB in the market for roller blades.
DEMAND AND PRICES AFTER CHANGES IN TASTES
Price
Price
S
PB
P1
P0
PA
DB
DA
Tennis Racquets Q Q
A
0
S
D
D
Quantity Roller blades Q1 QB Quantity
Suppose rollerblading starts to replace tennis. Demand shifts to DA in the
market in tennis racquets and DB in the market for roller blades. Prices of
rollerblades will rise to PB, prices of tennis racquets will fall to PA.
PRICES AND ECONOMIC
COORDINATION
• The change in tastes from tennis racquets to
rollerblading has caused the economy to produce
more roller blades and fewer tennis racquets
• The economy accomplishes this through prices
• When roller blading became more popular than
tennis, the price of roller blades rose and the
price of tennis racquets fell
• The producers of roller blades were given a signal
to step up production
• The producers of tennis racquets were given a
signal to cut back their production
• Workers will leave tennis racquet industry to be
employed by roller blade industry
FUTURE PRICES
• There is no price for automobiles to be
delivered five years from now, so
automobiles do not receive any direct
signals that consumers wish to purchase
automobiles in the future
• Only a few commodities, such as metals
and certain agricultural commodities, can
be traded for future delivery in worldwide
markets
TOO LITTLE INFORMATION
• Prices may not always contain all the
information that producers need
• What matters to any firm is the real price:
its price relative to all other prices in the
economy
• Reality Principle: What matters to people is
the real value or purchasing power of
money or income, not its face value
TOO LITTLE INFORMATION
• Problems can occur if firms are uncertain
about whether a change in their output
price is an increase in the real price or only
on the nominal or dollar price
• If producers believe demand for their
product has fallen, they will cut back
production
• If this happened throughout the economy, it
would lead to a recession
“STICKY” PRICES
• If prices are “sticky” or not sufficiently flexible,
prices will not coordinate activity as efficiently
• In modern economies, some prices are flexible,
while others are not
• Auction Prices -- those determined on nearly a
daily basis
• Prices for fresh fish, vegetables, and other food
are very flexible
• Custom Prices -- those that adjust rather slowly
• Prices for industrial commodities, such as steel
rods or machine tools, are custom prices
STICKY PRICES IN THE MARKET FOR TENNIS RACQUETS
Price
S
P0
E
D
Tennis Racquets
Q0
Quantity
STICKY PRICES IN THE MARKET FOR TENNIS RACQUETS
Price
S
P0
F
E
DA
Tennis Racquets
Q0
D
Quantity
STICKY PRICES IN THE MARKET FOR TENNIS RACQUETS
Price
S
P0
F
E
DA
Tennis Racquets
Q0
D
Quantity
STICKY PRICES IN THE MARKET FOR TENNIS RACQUETS
Price
S
P0
F
E
DA
Tennis Racquets
Q0
D
Quantity
When demand falls to DA, prices are sticky and remain at P0. The result
is unsold production measured by the distance between E and F.
WAGES
• Wages, the price of labor, adjust extremely slowly
• Workers often have long-term contracts that do
not allow wages to change at all during a given
year
• Even unskilled, low-wage workers are often
protected from decreases in their wages by
minimum wage laws
• For most firms, wages are the single most
important cost of doing business
• If wages are sticky, their overall costs will be
sticky
• Stickiness of wages reinforces stickiness of
prices
SHORT-RUN PRICES ARE
STICKY
• Firms let demand determine level of output in the
short run
• Automaker may have higher demand if autos are
popular or lower demand if autos are unpopular
• Steelmaker who provides steel to automaker may
provide more or less steel without adjusting price
• The same principle applies to workers
• During good times a company will employ many
workers and may even require some to work
overtime with no wage change
• The short run in macroeconomics is the period
when prices are fixed
LONG-RUN PRICES
• In the long run, price adjust fully to changes
in demand
• Over short periods of time, the presence of
formal and informal contracts mean that
demand will be reflected primarily in
changes in output, not prices
AGGREGATE DEMAND
• The aggregate demand curve plots the total
demand for GDP as a function of price level
• The aggregate demand curve is downward
sloping
• As the price level falls, the total demand for
goods and services increases
AGGREGATE DEMAND
Price Level
P
AD: aggregate demand
Real GDP, Y
The aggregate demand curve plots the total demand for real GDP as a
function of the price level.
The aggregate demand curve slopes
downward, indicating that aggregate demand increases as the price level
falls.
REALITY PRINCIPLE
What matters to people is the
real value or purchasing
power of money or income,
not its face value.
WEALTH EFFECT
• Increase in spending that occurs
because the real value of money
increases when the price level falls
• One of the key reasons that
aggregate demand slopes downward
TWO OTHER REASONS WHY DEMAND
CURVE SLOPES DOWNWARD
• Interest rate effect
With a given supply of money in the economy, a
lower price level will lead to lower interest rates
As interest rates fall, demand for investment
goods in the economy increase.
• Effects from international trade
In an open economy, a lower price level will
mean that domestic goods become cheaper
relative to foreign goods and demand for
domestic goods will increase
SHIFTS OF AGGREGATE
DEMAND
• At any price level, an increase in
aggregate demand means that total
demand for real GDP has increased, and
the curve shifts to the right
• Factors that decrease the aggregate
demand will shift the aggregate demand
curve to the left
• At any price level, a decrease in aggregate
demand means that total demand for real
GDP has decreased
KEY FACTORS THAT SHIFT THE
AGGREGATE DEMAND CURVE
• Changes in the supply of
money
• Changes in taxes
• Changes in government
spending
• other factors
CHANGES IN THE SUPPLY OF MONEY
• An increase in the supply of money in the
economy will increase aggregate demand
and shift the demand curve right
• At any price level, a higher supply of money
will mean more consumer wealth and an
increased demand for goods and services
• A decrease in the supply of money will
decrease aggregate demand and shift the
aggregate demand curve to the left
CHANGES IN TAXES
• A decrease in taxes will increase aggregate
demand and shift the aggregate demand
curve to the right
• Lower taxes will increase income available
to households and increase their spending
on goods and services
• Increases in taxes will decrease the
aggregate demand and shift the aggregate
demand curve left
CHANGES IN GOVERNMENT
SPENDING
• An increase in government spending will increase
aggregate demand and shift the aggregate
demand curve right
• Since the government is a source of demand for
goods and services, higher government spending
naturally leads to an increase in total demand for
goods and services
• Decreases in government spending will decrease
aggregate demand and shift the curve to the left
OTHER FACTORS
• Any change in demand from
households, firms, or the foreign
sector will also change aggregate
demand
• When shifts in aggregate demand are
discussed, any changes that arise
from movements in the price level
are not to be included
FACTORS THAT SHIFT
DEMAND
Factors That Increase
Aggregate Demand
Decrease in Taxes
Increase in
Government Spending
Increase in Money
Supply
Factors That Decrease
Aggregate Demand
Increase in Taxes
Decrease in
Government Spending
Decrease in Money
Supply
SHIFTING AGGREGATE DEMAND
Price Level
P
Original aggregate demand
Output, Y
SHIFTING AGGREGATE DEMAND
Price Level
P
Increased aggregate demand
Original aggregate demand
Output, Y
SHIFTING AGGREGATE DEMAND
Price Level
P
Increased aggregate demand
Original aggregate demand
Output, Y
Decreases in taxes, increases in government spending, or an increase in
the supply of money all shift the aggregate demand curve to the right.
SHIFTING AGGREGATE DEMAND
Price Level
P
Increased aggregate demand
Original aggregate demand
Decreased aggregate demand
Output, Y
Decreases in taxes, increases in government spending, or an increase in
the supply of money all shift the aggregate demand curve to the right.
SHIFTING AGGREGATE DEMAND
Price Level
P
Increased aggregate demand
Original aggregate demand
Decreased aggregate demand
Output, Y
Decreases in taxes, increases in government spending, or an increase in
the supply of money all shift the aggregate demand curve to the right.
Higher taxes, lower government spending, or a lower supply of money
AGGREGATE SUPPLY
• Depicts the relationship between the level
of prices and real GDP
• Two different aggregate supply curves,
which correspond to the long run and the
short run:
-- classical aggregate supply curve
-- Keynesian aggregate supply curve
CLASSICAL AGGREGATE
SUPPLY CURVE
• Aggregate supply curve for the long run
when the economy is at full employment
• Full-employment output depends solely on
the supply of capital and labor and the state
of technology
• full-employment output does not depend on
the price level
• Classical aggregate supply curve is plotted
as a vertical line (unaffected by prices)
CLASSICAL AGGREGATE SUPPLY
AS
Price
p
y*
Output, y
In the long run, the level of output y* is independent of the price level.
Price
AGGREGATE DEMAND AND
CLASSICAL AGGREGATE SUPPLY
p
Classical
AS
Original AD
y*
Output, y
Output and prices are determined at the intersection of AD and AS.
COMBINING AGGREGATE DEMAND
AND AGGREGATE SUPPLY
• The price level and level of output are determined
by the intersection of aggregate supply and
aggregate demand
• At that point, total amount demanded will just
equal the total amount supplied
• The position of the aggregate demand curve will
depend on the level of taxes, government
spending, and the supply of money
• The full-employment output determines the
classical aggregate supply curve
Price
AGGREGATE DEMAND AND
CLASSICAL AGGREGATE SUPPLY
p
Classical
AS
Increased AD
Original AD
y*
Output, y
Output and prices are determined at the intersection of AD and AS.
An increase in aggregate demand to a higher price level.
COMBINING AGGREGATE DEMAND
AND AGGREGATE SUPPLY
• An increase in demand will shift the
aggregate demand curve right
• With a classical aggregate supply curve, the
increase in aggregate demand will raise the
prices but leave the level of output
unchanged
THE KEYNESIAN AGGREGATE SUPPLY
CURVE
• The Keynesian aggregate supply curve is
horizontal in the short run
• Firms are assumed to supply all output that
is demanded at the current price
• Formal and informal contracts commit
producers to supply all that is demanded at
the going price
• The entire Keynesian supply curve can
shift up or down as prices adjust to their
long-run levels
KEYNESIAN AGGREGATE SUPPLY
Price
p
Keynesian AS
p0
Output, y
Price
AGGREGATE DEMAND AND
KEYNESIAN AGGREGATE SUPPLY
p
E0
Keynesian AS
p0
Original AD
y0
Output, y
Price
AGGREGATE DEMAND AND
KEYNESIAN AGGREGATE SUPPLY
p
E0
E1
Keynesian AS
p0
Increased AD
Original AD
y0
y1
Output, y
With a Keynesian aggregate supply curve, shifts in aggregate demand
lead to changes in output but no changes in prices.
AGGREGATE DEMAND AND KEYNESIAN
AGGREGATE SUPPLY CURVES
• The intersection of AD and AS curves determines
the price level and the level of output at point E
• Since aggregate demand is horizontal, aggregate
demand totally determines the level of output
• As aggregate demand increases, the new
equilibrium will be at the same price p0, but output
will increase from y0 to y1
• The Keynesian aggregate supply curve need not
correspond to full-employment output
• Changes in demand will lead to economic
fluctuations with sticky prices and a Keynesian
aggregate supply curve
SUPPLY SHOCKS
• External disturbances that shift the aggregate
supply curve
• Most important illustrations of supply shocks for
the world economy have been sharp increases in
the price of oil that occurred in 1973 and 1979
– When oil prices increased sharply, firms would no
longer sell all the goods and services that were
demanded at the current price
– To maintain their profit levels, firms raised their prices
A SUPPLY SHOCK
Price
p
AS (before the
shock)
p0
AD
y0
Output, y
A SUPPLY SHOCK
Price
p
AS (after the
shock)
AS (before the
shock)
p0
AD
y0
Output, y
An adverse supply shock, such as an increase in the price of oil, will
shift up the AS curve.
A SUPPLY SHOCK
Price
p
p1
AS (after the
shock)
p0
AS (before the
shock)
AD
y1
y0
Output, y
An adverse supply shock, such as an increase in the price of oil, will
shift up the AS curve. The result will be higher prices and a lower level
of output.
LINKS BETWEEN SHORT RUN
AND LONG RUN
• Provided by adjustments of wages and
prices
-- sticky and do not move immediately in
the short run
-- Over time adjust and the economy
reaches its long-run equilibrium
• Wage and price adjustments provide the
links between Keynesian and classical
economics
WAGES AND PRICES IN AN ECONOMY
PRODUCING AT A LEVEL ABOVE FULL
EMPLOYMENT
•
•
•
•
The Wage Price Spiral
Firms find it increasingly difficult to hire and
retain workers
Workers find it easy to obtain a job and easy to
change jobs
To attract workers and to prevent others from
quitting, firms raise their wages to try to outbid
their competitors
The actions of firms start a process in which
wages increase throughout the economy
PRICES IN AN ECONOMY PRODUCING AT A
LEVEL ABOVE FULL EMPLOYMENT
The Wage Price Spiral
• For most firms, wages are the largest single cost
of production
• As their labor costs increase, firms have no
choice but to increase prices as well
• As prices rise, workers know they need higher
dollar or nominal wages to maintain their real
wage
The Reality Principle
What matters to people is the real value or
purchasing power of money or income, not its
face value
UNEMPLOYMENT, OUTPUT, AND WAGES AND
PRICE CHANGES
When unemployment is
below the natural rate above the natural rate
output is
above potential
below potential
wages and prices
rise
fall
• When output exceeds potential output, wages and
prices throughout the economy will rise above the
previous inflation rate
• If output is less than potential output, wages and
prices will fall to previous inflation rates
AGGREGATE DEMAND
• The aggregate demand curve is
plotted with the price on the vertical
axis and real output on the horizontal
axis
• It shows the total level of demand for
goods and services for any level of
output
AGGREGATE SUPPLY
• The classical aggregate supply curve (long
run) is a vertical line at the fullemployment level of output
• The Keynesian aggregate supply curve
(short run) is a horizontal line at the current
level of prices
• The Keynesian aggregate supply curve is
horizontal because changes in demand
lead to very small changes in prices over
short periods of time
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Price , p
AD
Output, y
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Price , p
Keynesian AS
AD
Output, y
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Price , p
A
p0
Keynesian AS
AD
Output, y
y0
The aggregate demand curve, AD, intersects the Keynesian
aggregate supply curve at point A.
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Price , p
Classical AS
A
p0
Keynesian AS
AD
Output, y
y0
The aggregate demand curve, AD, intersects the Keynesian
aggregate supply curve at point A.
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Price , p
pF
p0
Classical AS
D
A
Keynesian AS
AD
Output, y
yF
y0
The aggregate demand curve, AD, intersects the Keynesian
aggregate supply curve at point A and the classical
aggregate supply curve at point D.
RELATING KEYNESIAN TO CLASSICAL
POSITIONS
• At the intersection of aggregate demand and
Keynesian aggregate supply curves, the current
level of output Y0, exceeds the full-employment
level of output, YF
• Unemployment rate is below the natural rate
• Firms find it difficult to hire and retain workers,
and wage-price spiral begins
• As level of prices increase, Keynesian aggregate
supply curve shifts up over time
• The shift in the Keynesian aggregate supply curve
will bring the economy to long-run equilibrium
-- the intersection of classical AS and AD
SHIFTS IN KEYNESIAN AGGREGATE SUPPLY
Price , p
p0
A
AS0
AD
y0
Output, y
As prices rise in the economy, the Keynesian aggregate supply curve
shifts up.
SHIFTS IN KEYNESIAN AGGREGATE SUPPLY
Price , p
p1
p0
B
AS1
AS0
A
AD
y0
Output, y
As prices rise in the economy, the Keynesian aggregate supply curve
shifts up. The economy moves from point A to point B.
SHIFTS IN KEYNESIAN AGGREGATE SUPPLY
Price , p
p2
p1
p0
C
AS2
AS1
B
A
AS0
AD
y0
Output, y
As prices rise in the economy, the Keynesian aggregate supply curve
shifts up. The economy moves from point A to point B. The process
will continue.
SHIFTS IN KEYNESIAN AGGREGATE SUPPLY
Price , p
p3
p2
p1
p0
D
AS3
AS2
AS1
C
B
A
AS0
AD
y0
Output, y
As prices rise in the economy, the Keynesian aggregate supply curve
shifts up. The economy moves from point A to point B. The process
will continue until the economy reaches point D.
SHIFTS IN KEYNESIAN AGGREGATE SUPPLY
Price , p
p3
p2
p1
D
AS3
AS2
AS1
C
B
A
p0
AS0
AD
yF
y0
Output, y
As prices rise in the economy, the Keynesian aggregate supply curve
shifts up. The economy moves from point A to point B. The process
will continue until the economy reaches point D. The price-wage spiral
stops when the economy reaches full employment. Unemployment is
at the natural rate.
Price , p
p0
RETURNING TO FULL EMPLOYMENT
A
AS0
AD
Output, y
If the initial level of output is less than full employment,
Price , p
p0
RETURNING TO FULL EMPLOYMENT
A
AS0
p1
AS1
AD
Output, y
If the initial level of output is less than full employment,
wages and prices will fall.
Price , p
p0
p1
RETURNING TO FULL EMPLOYMENT
A
AS0
B
AS1
AD
Output, y
If the initial level of output is less than full employment,
wages and prices will fall.
Price , p
p0
p1
p2
RETURNING TO FULL EMPLOYMENT
A
AS0
B
AS1
D
AS2
AD
Output, y
If the initial level of output is less than full employment,
wages and prices will fall.
Price , p
p0
p1
RETURNING TO FULL EMPLOYMENT
A
AS0
B
AS1
D
p2
AS2
AD
yF
Output, y
If the initial level of output is less than full employment,
wages and prices will fall. As the aggregate supply curve
shifts down, the economy will return to full employment
at D.
Price , p
p0
p1
RETURNING TO FULL EMPLOYMENT
A
AS0
B
AS1
D
p2
AS2
AD
yF
Output, y
If the initial level of output is less than full employment,
wages and prices will fall. As the aggregate supply curve
shifts down, the economy will return to full employment
at D.
THE ECONOMY WILL EVENTUALLY
RETURN TO FULL EMPLOYMENT
• If output exceeds full employment,
prices will rise and output will fall
back to full employment
• If output is less than full
employment, prices will fall as the
economy returns to full employment
MOVING FROM THE SHORT TO THE LONG
RUN
• Economists disagree about the time it takes:
range between 2 and 6 years
• Alternatives bring long-run (full employment)
about
-- Do nothing and allow adjustment process, with
falling wages and prices to return the
economy
to full employment
-- Use expansionary policies (open market
purchases, increases in government spending
or tax cuts) to shift the aggregate demand
curve right
-- Use contractionary policies to reduce demand /
level of GDP until it reaches potential output
USING ECONOMIC POLICY TO FIGHT A RECESSION
Price , p
p0
A
yF
AD0
Output, y
USING ECONOMIC POLICY TO FIGHT A RECESSION
Price , p
p0
A
D
yF
AD0
Output, y
USING ECONOMIC POLICY TO FIGHT A RECESSION
Price , p
p0
A
D
yF
AD0
Output, y
Rather than letting the economy naturally return to full
employment at D,
USING ECONOMIC POLICY TO FIGHT A RECESSION
Price , p
p0
A
D
yF
AD1
AD0
Output, y
Rather than letting the economy naturally return to full
employment at D, we can increase aggregate demand
from AD0 to AD1
USING ECONOMIC POLICY TO FIGHT A RECESSION
Price , p
p0
E
A
D
yF
AD1
AD0
Output, y
Rather than letting the economy naturally return to full
employment at D, we can increase aggregate demand
from AD0 to AD1 to bring the economy to full employment
at E.
ACTIVE ECONOMIC POLICIES AND
ECONOMIC STABILITY
• Active economic policies are more likely to
destabilize the economy if the adjustment process
operates quickly
• Economists who believe the economy adjusts
rapidly to full employment generally oppose using
monetary or fiscal policy to try to stabilize the
economy
• Economists who believe the adjustment process
operates slowly are more sympathetic to using
monetary or fiscal policy to stabilize the economy
• It is possible for the speed of adjustment to vary
over time, making decisions about policy more
difficult
THE ADJUSTMENT
PROCESS
• Interest rates are determined by the
demand and supply of money
• Interest rates determine the level of
investment spending in the economy
• Investment spending, along with
consumption, government spending
and net exports determines the level
of GDP
MODEL OF DEMAND WITH MONEY
Interest
s
Rates M
r0
A
MODEL OF DEMAND WITH MONEY
Interest
s
Rates M
Interest
Rates
r0
r0
Md
(P0 )
Money
A
I0 Investment
B
MODEL OF DEMAND WITH MONEY
Interest
s
Rates M
Interest
Rates
Total
Demand
450
r0
r0
Md
(P0 )
Money
A
I0 Investment
B
y0
C
Output
MODEL OF DEMAND WITH MONEY
Interest
s
Rates M
Interest
Rates
Total
Demand
450
r0
Md
(P0 )
Money
A
I0 Investment
B
y0 yF Output
C
At the current price level, P0, the economy is producing y0, which is
below full employment, yF
APPLYING THE REALITY PRINCIPLE
Reality Principle: What matters to people is
the real value or purchasing power of
money or income, not its face value.
• The amount of money that people want to
hold will depend on the price level
• If prices are cut in half, you need to hold
only half as much money to purchase the
same goods and services
• Decreases in the price level will cause the
money demand curve to shift left
RETURNING TO FULL EMPLOYMENT
Interest
s
Rates M
Interest
Rates
r0
Total
Demand
450
r0
Md
(P0 )
Money
A
I0 Investment
B
When output is below full employment, the price level falls
y0 yF Output
C
RETURNING TO FULL EMPLOYMENT
Interest
s
Rates M
Interest
Rates
r0
Total
Demand
450
r0
Md
(P0 )
Money
A
I0 Investment
B
y0 yF Output
C
When output is below full employment, the price level falls. This reduces
the demand for money and interest rates.
RETURNING TO FULL EMPLOYMENT
Interest
s
Rates M
Interest
Rates
r0
r0
r1
M d r1
Md (P0 )
(P1)
Money
A
Total
Demand
I0 Investment
B
450
y0 yF Output
C
When output is below full employment, the price level falls. This reduces
the demand for money and interest rates.
RETURNING TO FULL EMPLOYMENT
Interest
s
Rates M
Interest
Rates
r0
r0
r1
M d r1
Md (P0 )
(P1)
Money
A
Total
Demand
I0
I1 Investment
B
450
y0 yF Output
C
When output is below full employment, the price level falls. This reduces
the demand for money and interest rates. Lower interest rates increase
investment
RETURNING TO FULL EMPLOYMENT
Interest
s
Rates M
Interest
Rates
r0
r0
r1
M d r1
Md (P0 )
(P1)
Money
A
Total
Demand
I0
I1 Investment
B
450
y0 yF Output
C
When output is below full employment, the price level falls. This reduces
the demand for money and interest rates. Lower interest rates increase
investment and stimulate spending.
RETURNING TO FULL EMPLOYMENT
Interest
s
Rates M
Interest
Rates
r0
r0
r1
M d r1
Md (P0 )
(P1)
Money
A
Total
Demand
I0
I1 Investment
B
450
y0 yF Output
C
When output is below full employment, the price level falls. This reduces
the demand for money and interest rates. Lower interest rates increase
investment and stimulate spending. The economy returns to full
employment.
IF OUTPUT IS BELOW FULL EMPLOYMENT
• Unemployment exceeds the natural rate, and
there will be excess unemployment
• Wages and prices will start to fall
• Falling prices will decrease the demand for
holding money
• Interest rates will fall
• Investment spending will increase with falling
interest rates
• As investment increases, the total demand line
shifts up and raises the level of output until fullemployment output is reached
• This process works in reverse if output exceeds
potential
NEUTRALITY OF MONEY
Interest
s
Rates M 0
Interest
Rates
rF
Total
Demand
450
rF
Md
Money
A
Starting at full employment,
I
IF
I0
Investment
B
yF
C
Output
NEUTRALITY OF MONEY
Interest
s
s
Rates M 0 M 1
Interest
Rates
rF
r0
Total
Demand
450
rF
r0
Md
Money
A
I
IF
I0
Investment
B
yF y0 Output
C
Starting at full employment, an increase in the supply of money will initially
reduce interest rates from rF to r0, raise investment spending from I F to I 0 and
increase output above full employment from yF to y0.
NEUTRALITY OF MONEY
Interest
s
s
Rates M 0 M 1
Interest
Rates
rF
r0
Total
Demand
450
rF
r0
Md
Money
A
I
IF
I0
Investment
B
yF y0 Output
C
Starting at full employment, an increase in the supply of money will initially
reduce interest rates from rF to r0, raise investment spending from IF to I0 and
increase output above full employment from yF to y0. As wages and prices
increase, the demand for money increases
NEUTRALITY OF MONEY
Interest
s
s
Rates M 0 M 1
Interest
Rates
rF
r0
Total
Demand
450
rF
r0
Md
Money
A
I
IF
I0
Investment
B
yF y0 Output
C
Starting at full employment, an increase in the supply of money will initially
reduce interest rates from rF to r0, raise investment spending from IF to I0 and
increase output above full employment from yF to y0. As wages and prices
increase, the demand for money increases, restoring interest rates, investment
and output to full employment.
•
•
•
•
•
•
•
LONG-RUN EFFECTS OF AN INCREASE IN THE
MONEY SUPPLY
If the economy is at full employment and the Bank
increases the money supply:
In the Short Run
Interest rates will decline
The level of investment spending will increase
The increased demand for output will raise the
output above full employment
In the Long Run
Wages and prices will start to increase
The demand for money will increase
Interest Rates will increase
Investment will start to fall and output will fall
LONG-RUN NEUTRALITY OF
MONEY
In the long run, increases in
the supply of money have no
effect on real variables, only on
prices.