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Aggregate Demand
in the Goods and
Money Markets
12
CHAPTER OUTLINE
Planned Investment and the Interest Rate
Other Determinants of Planned Investment
Planned Aggregate Expenditure and the Interest Rate
Equilibrium in Both the Goods and Money Markets:
The IS-LM Model
PART III The Core of Macroeconomic Theory
Policy Effects in the Goods and Money Markets
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Expansionary Policy Effects
Contractionary Policy Effects
The Macroeconomic Policy Mix
The Aggregate Demand (AD) Curve
The Aggregate Demand Curve: A Warning
Other Reasons for a Downward-Sloping Aggregate Demand
Curve
Shifts of the Aggregate Demand Curve from Policy Variables
Looking Ahead: Determining the Price Level
Appendix: The IS-LM Model
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PART III The Core of Macroeconomic Theory
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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PART III The Core of Macroeconomic Theory
Planned Investment and the Interest Rate
 FIGURE 12.1 Planned Investment Schedule
Planned investment spending is a negative function of the interest rate.
An increase in the interest rate from 3 percent to 6 percent reduces planned investment from I0 to I1.
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Planned Investment and the Interest Rate
Other Determinants of Planned Investment
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.
PART III The Core of Macroeconomic Theory
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.
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EC ON OMIC S IN PRACTICE
Small Business and the Credit Crunch
PART III The Core of Macroeconomic Theory
We know how a firm’s
investment decisions
depend on the
interest rate.
In the recession of
2008–2009 some
firms—especially
small ones—were
discouraged from
investing, not by high
interest rates, but by
the general
unwillingness of
banks to lend them
money at all.
Bailout Missed Main Street, New Report Says
The Wall Street Journal
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Planned Investment and the Interest Rate
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.
PART III The Core of Macroeconomic Theory
Recall that planned aggregate expenditure is the sum of consumption,
planned investment, and government purchases.
That is,
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AE ≡ C + I + G
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Planned Investment and the Interest Rate
PART III The Core of Macroeconomic Theory
Planned Aggregate Expenditure and the Interest Rate
 FIGURE 12.2 The Effect of an Interest Rate Increase on Planned Aggregate Expenditure
An increase in the interest rate from 3 percent to 6 percent lowers planned
aggregate expenditure and thus reduces equilibrium income from Y0 to Y1.
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Planned Investment and the Interest Rate
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).
PART III The Core of Macroeconomic Theory
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.
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Planned Investment and the Interest Rate
Planned Aggregate Expenditure and the Interest Rate
Using a convenient shorthand:
PART III The Core of Macroeconomic Theory
r  I  AE  Y 
r  I  AE  Y 
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Equilibrium in Both the Goods and Money Markets: The IS-LM Model
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) increases, this shifts the money demand curve to the right,
which increases the interest rate (r) with a fixed money supply.
PART III The Core of Macroeconomic Theory
We can thus write:
Y  M  r 
d
Y  M  r 
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d
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PART III The Core of Macroeconomic Theory
Equilibrium in Both the Goods and Money Markets: The IS-LM Model
 FIGURE 12.3 Links between the Goods Market and the Money Market
Planned investment depends on the interest rate, and money demand depends on aggregate output.
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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 aimed at increasing
aggregate output (income) (Y).
PART III The Core of Macroeconomic Theory
expansionary monetary policy An increase in the money
supply aimed at increasing aggregate output (income) (Y).
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Policy Effects in the Goods and Money Markets
Expansionary Policy Effects
Expansionary Fiscal Policy: An Increase in Government Purchases (G)
or a Decrease in Net Taxes (T)
PART III The Core of Macroeconomic Theory
crowding-out effect The tendency for
increases in government spending to cause
reductions in private investment spending.
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Policy Effects in the Goods and Money Markets
Expansionary Policy Effects
Expansionary Fiscal Policy: An Increase in Government Purchases (G)
or a Decrease in Net Taxes (T)
PART III The Core of Macroeconomic Theory
 FIGURE 12.4 The Crowding-Out
Effect
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.
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Policy Effects in the Goods and Money Markets
Expansionary Policy Effects
PART III The Core of Macroeconomic Theory
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.
Effects of an expansionary fiscal policy:
G  Y  M d  r  I 
Y increasesless than if r did not increase
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Policy Effects in the Goods and Money Markets
Expansionary Policy Effects
Expansionary Monetary Policy: An Increase in the Money Supply
Effects of an expansionary monetary policy:
PART III The Core of Macroeconomic Theory
M s  r  I  Y  M d 
r decreasesless than if M
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d
did not increase
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Policy Effects in the Goods and Money Markets
Contractionary Policy Effects
Contractionary Fiscal Policy: A Decrease in Government Spending (G)
or an Increase in Net Taxes (T)
PART III The Core of Macroeconomic Theory
contractionary fiscal policy A decrease in
government spending or an increase in net taxes
aimed at decreasing aggregate output (income) (Y).
Effects of a contractionary fiscal policy:
G  or T  Y  M d  r  I 
Y decreasesless than if r did not decrease
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Policy Effects in the Goods and Money Markets
Contractionary Policy Effects
Contractionary Monetary Policy: A Decrease in the Money Supply
PART III The Core of Macroeconomic Theory
contractionary monetary policy A decrease in the money
supply aimed at decreasing aggregate output (income) (Y).
Effects of a contractionary monetary policy:
M s  r  I  Y  M d 
r increasesless than if M
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d
did not decrease
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Policy Effects in the Goods and Money Markets
The Macroeconomic Policy Mix
policy mix The combination of monetary and fiscal policies in use at
a given time.
TABLE 12.1 The Effects of the Macroeconomic Policy Mix
PART III The Core of Macroeconomic Theory
Fiscal Policy
Expansionary
Contractionary
( G or  T )
( G or  T )
Expansionary
( M s )
Y , r ?, I ?, C 
Y ?, r , I , C ?
Contractionary
( M s )
Y ?, r , I , C ?
Y , r ?, I ?, C 
Monetary
Policy
Key :
: Variable increases.
: Variable decreases.
? : Forces push the variable in different directions . Without additional informatio n, we cannot
specify which way the variable moves.
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The Aggregate Demand (AD) Curve
PART III The Core of Macroeconomic Theory
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.
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PART III The Core of Macroeconomic Theory
The Aggregate Demand (AD) Curve
 FIGURE 12.5 The Impact of an Increase in the Price Level on the Economy—Assuming No Changes in G, T, and Ms
This figure shows that when P increases, Y decreases.
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The Aggregate Demand (AD) Curve
 FIGURE 12.6 The Aggregate Demand (AD)
Curve
PART III The Core of Macroeconomic Theory
At all points along the AD curve, both the
goods market and the money market are in
equilibrium.
The policy variables G, T, and Ms are fixed.
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The Aggregate Demand (AD) Curve
The Aggregate Demand Curve: A Warning
It is important that you realize what the aggregate demand curve
represents.
PART III The Core of Macroeconomic Theory
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.
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The Aggregate Demand (AD) Curve
Other Reasons for a Downward-Sloping Aggregate Demand Curve
The Consumption Link
PART III The Core of Macroeconomic Theory
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).
The initial decrease in consumption (brought about by the
increase in the interest rate) contributes to the overall
decrease in output.
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The Aggregate Demand (AD) Curve
Other Reasons for a Downward-Sloping Aggregate Demand Curve
The Real Wealth Effect
PART III The Core of Macroeconomic Theory
real wealth, or real balance, effect The change
in consumption brought about by a change in real
wealth that results from a change in the price level.
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The Aggregate Demand (AD) Curve
Shifts of the Aggregate Demand Curve from Policy Variables
PART III The Core of Macroeconomic Theory
 FIGURE 12.7 The Effect of an Increase in
Money Supply on the AD Curve
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.
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The Aggregate Demand (AD) Curve
Shifts of the Aggregate Demand Curve from Policy Variables
PART III The Core of Macroeconomic Theory
 FIGURE 12.8 The Effect of an Increase in
Government Purchases or a Decrease in Net
Taxes 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.
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The Aggregate Demand (AD) Curve
PART III The Core of Macroeconomic Theory
Shifts of the Aggregate Demand Curve from Policy Variables
 FIGURE 12.9 Factors That Shift the Aggregate Demand Curve
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Looking Ahead: Determining the Price Level
Our discussion of aggregate output (income) and the interest rate in the goods
and money markets is now complete. You should have a good understanding of
how the two markets work together.
PART III The Core of Macroeconomic Theory
The AD curve is a useful summary of this analysis in that every point on the
curve corresponds to equilibrium in both the goods and money markets for the
given value of the price level.
We have not yet, however, determined the price level. This is the task of the
next chapter.
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REVIEW TERMS AND CONCEPTS
aggregate demand (AD) curve
contractionary fiscal policy
contractionary monetary policy
crowding-out effect
expansionary fiscal policy
PART III The Core of Macroeconomic Theory
expansionary monetary policy
goods market
interest sensitivity or insensitivity of planned investment
money market
policy mix
real wealth, or real balance, effect
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CHAPTER 12 APPENDIX
The IS-LM Model
The IS Curve
 FIGURE 12A.1 The IS Curve
PART III The Core of Macroeconomic Theory
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.
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CHAPTER 12 APPENDIX
The IS-LM Model
The LM Curve
 FIGURE 12A.2 The LM Curve
PART III The Core of Macroeconomic Theory
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.
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CHAPTER 12 APPENDIX
The IS-LM Model
The IS-LM Diagram
 FIGURE 12A.3 The IS-LM Diagram
PART III The Core of Macroeconomic Theory
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.
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CHAPTER 12 APPENDIX
The IS-LM Model
PART III The Core of Macroeconomic Theory
The IS-LM Diagram
 FIGURE 12A.4 An Increase in Government Purchases (G)
When G increases, the IS curve shifts to the right.
This increases the equilibrium value of both Y and r.
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CHAPTER 12 APPENDIX
The IS-LM Model
PART III The Core of Macroeconomic Theory
The IS-LM Diagram
 FIGURE 12A.5 An Increase in the Money Supply (Ms)
When Ms increases, the LM curve shifts to the right.
This increases the equilibrium value of Y and decreases the equilibrium value of r.
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CHAPTER 12 APPENDIX
The IS-LM Model
The IS-LM Diagram
The IS-LM diagram is a useful way of seeing the effects of changes in
monetary and fiscal policies on equilibrium aggregate output (income) and
the interest rate through shifts in the two curves.
PART III The Core of Macroeconomic Theory
Always keep in mind the economic theory that lies behind the two curves.
Do not memorize what curve shifts when; be able to understand and
explain why the curves shift.
This means going back to the behavior of households and firms in the
goods and money markets.
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APPENDIX REVIEW TERMS AND CONCEPTS
PART III The Core of Macroeconomic Theory
IS curve A curve illustrating the negative relationship
between the equilibrium value of aggregate output
(income) (Y) and the interest rate in the goods market.
LM curve A curve illustrating the positive relationship
between the equilibrium value of the interest rate and
aggregate output (income) (Y) in the money market.
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