Principles of macroeconomics 10e by case fair oster ch12

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: T

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

Policy Effects in the Goods and Money Markets

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

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

© 2012 Pearson Education, Inc Publishing as Prentice Hall

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.

 FIGURE 12.1 Planned Investment Schedule

Planned Investment and the Interest Rate

Reducing the interest rate, ceteris paribus, is likely to:

a Increase the level of planned investment spending

b Decrease the level of planned investment

c Shift the demand for money curve to the right

d Shift the supply of money curve to the right

© 2012 Pearson Education, Inc Publishing as Prentice Hall

Reducing the interest rate, ceteris paribus, is likely to:

a Increase the level of planned investment spending.

b Decrease the level of planned investment

c Shift the demand for money curve to the right

d Shift the supply of money curve to the right

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 Investment and the Interest Rate

Other Determinants of Planned Investment

© 2012 Pearson Education, Inc Publishing as Prentice Hall

We know how a firm’s

investing, not by high

interest rates, but by

Bailout Missed Main Street, New Report Says

The Wall Street Journal

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

That is,

AE ≡ C + I + G

Planned Investment and the Interest Rate

Planned Aggregate Expenditure and the Interest Rate

© 2012 Pearson Education, Inc Publishing as Prentice Hall

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.

 FIGURE 12.2 The Effect of an Interest Rate Increase on Planned Aggregate Expenditure

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).

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

Planned Investment and the Interest Rate

Planned Aggregate Expenditure and the Interest Rate

© 2012 Pearson Education, Inc Publishing as Prentice Hall

Fill in the blanks A higher interest rate planned investment and causes planned aggregate expenditure to shift _

d decreases; downward

© 2012 Pearson Education, Inc Publishing as Prentice Hall

Using a convenient shorthand:

Planned Investment and the Interest Rate

Planned Aggregate Expenditure and the Interest Rate

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

We can thus write:

Y

r M

Y

d d

Equilibrium in Both the Goods and Money Markets: The IS-LM Model

© 2012 Pearson Education, Inc Publishing as Prentice Hall

Which of the following statements describes the relationship between the goods market and the money market?

c A decrease in the interest rate

d An increase in both the supply and the demand for money

a An increase in money demand.

c A decrease in the interest rate

d An increase in both the supply and the demand for money

© 2012 Pearson Education, Inc Publishing as Prentice Hall

Planned investment depends on the interest rate, and money demand depends on aggregate output.

 FIGURE 12.3 Links between the Goods Market and the Money Market

Equilibrium in Both the Goods and Money Markets: The IS-LM Model

market are not linked in the ways described above.

© 2012 Pearson Education, Inc Publishing as Prentice Hall

Which of the following is a link between the goods market and the money market?

a Income has considerable influence on the demand for money in the money market

b The interest rate has significant effects on planned investment in the goods market

c Both a and b above.

market are not linked in the ways described above

aggregate output (income) (Y)

expansionary monetary policy An increase in the money

supply aimed at increasing aggregate output (income) (Y)

Policy Effects in the Goods and Money Markets

Expansionary Policy Effects

© 2012 Pearson Education, Inc Publishing as Prentice Hall

Which of the following policy changes would be considered

expansionary monetary policy?

Which of the following policy changes would be considered

expansionary monetary policy?

a An increase in the money supply.

© 2012 Pearson Education, Inc Publishing as Prentice Hall

crowding-out effect The tendency for increases in government spending to cause reductions in private investment spending

Expansionary Fiscal Policy: An Increase in Government Purchases (G)

or a Decrease in Net Taxes (T)

Policy Effects in the Goods and Money Markets

Expansionary Policy Effects

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

 FIGURE 12.4 The Crowding-Out

Effect

Expansionary Fiscal Policy: An Increase in Government Purchases (G)

or a Decrease in Net Taxes (T)

Policy Effects in the Goods and Money Markets

Expansionary Policy Effects

© 2012 Pearson Education, Inc Publishing as Prentice Hall

An increase in government spending (G),

a Increases planned aggregate expenditure, increases

aggregate output, but may also cause a decrease in planned investment, which reduces both planned aggregate

expenditure and aggregate output

b Increases planned aggregate expenditure, increases

aggregate output, and spurs even more planned investment, which further increases aggregate output

c Decreases aggregate expenditure, planned investment, and

aggregate output

d All of the cases above have equal chance of occurring

An increase in government spending (G),

a Increases planned aggregate expenditure, increases

aggregate output, but may also cause a decrease in planned investment, which reduces both planned aggregate expenditure and aggregate output.

b Increases planned aggregate expenditure, increases

aggregate output, and spurs even more planned investment, which further increases aggregate output

c Decreases aggregate expenditure, planned investment, and

aggregate output

d All of the cases above have equal chance of occurring

© 2012 Pearson Education, Inc Publishing as Prentice Hall

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:

increasenot

did

if thanless

Y

I r

M Y

G   d   

Expansionary Fiscal Policy: An Increase in Government Purchases (G)

or a Decrease in Net Taxes (T)

Policy Effects in the Goods and Money Markets

Expansionary Policy Effects

if thanless

© 2012 Pearson Education, Inc Publishing as Prentice Hall

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:

decreasenot

did

if thanless

decreases

or

r Y

I r

M Y

T

G    d   

Contractionary Fiscal Policy: A Decrease in Government Spending (G)

or an Increase in Net Taxes (T)

Policy Effects in the Goods and Money Markets

Contractionary Policy Effects

contractionary monetary policy A decrease in the money

supply aimed at decreasing aggregate output (income) (Y)

Effects of a contractionary monetary policy:

decreasenot

did

if thanless

Policy Effects in the Goods and Money Markets

Contractionary Policy Effects

Contractionary Monetary Policy: A Decrease in the Money Supply

© 2012 Pearson Education, Inc Publishing as Prentice Hall

policy mix The combination of monetary and fiscal policies in use at

(

ry

Expansiona

s M



) (

nary

Contractio

s M

?,r I C

Y   Y ,r?,I?,C

moves.

variable the

way which specify

cannot we

n, informatio additional

Without

directions different

in variable the

push Forces

:

?

decreases.

Variable

:

increases.

Variable

: Key



 :

Policy Effects in the Goods and Money Markets

The Macroeconomic Policy Mix

© 2012 Pearson Education, Inc Publishing as Prentice Hall

Which policy mix favors investment spending over government spending?

a Expansionary fiscal policy and contractionary monetary policy

b An increase in the money supply and a fall in government purchases.

c Both expansionary fiscal policy and expansionary monetary policy

d None of the above No policy mix favors investment over government spending

price level Each point on the AD curve is a point at which both

the goods market and the money market are in equilibrium

The Aggregate Demand (AD) Curve

© 2012 Pearson Education, Inc Publishing as Prentice Hall

This figure shows that when P increases, Y decreases.

 FIGURE 12.5 The Impact of an Increase in the Price Level on the Economy—Assuming No Changes in G, T, and Ms

The Aggregate Demand (AD) Curve

At all points along the AD curve, both the

goods market and the money market are

© 2012 Pearson Education, Inc Publishing as Prentice Hall

Let P equal the aggregate price level Assuming that G, T, and M S

remain the same, the impact of an increase in the price level on the economy can be described as follows:

a

Let P equal the aggregate price level Assuming that G, T, and M S

remain the same, the impact of an increase in the price level on the economy can be described as follows:

© 2012 Pearson Education, Inc Publishing as Prentice Hall

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

The Aggregate Demand (AD) Curve

The Aggregate Demand Curve: A Warning

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

Other Reasons for a Downward-Sloping Aggregate Demand Curve

The Consumption Link

The Aggregate Demand (AD) Curve

© 2012 Pearson Education, Inc Publishing as Prentice Hall

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

Other Reasons for a Downward-Sloping Aggregate Demand Curve

The Real Wealth Effect

The Aggregate Demand (AD) Curve

An increase in the money supply (M s)

causes the aggregate demand curve to

shift to the right, from AD0 to AD1

This shift occurs because the increase in

M s 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

Shifts of the Aggregate Demand Curve from Policy Variables

The Aggregate Demand (AD) Curve

© 2012 Pearson Education, Inc Publishing as Prentice Hall

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

Shifts of the Aggregate Demand Curve from Policy Variables

The Aggregate Demand (AD) Curve

Along the aggregate demand curve, each point represents:

a Equilibrium in the goods market, regardless of the equilibrium

situation in the money market

b Equilibrium in the money market, regardless of the

equilibrium situation in the goods market

c Simultaneous equilibrium in both the goods and money

markets

d Macroeconomic equilibrium, or equilibrium in all markets of

the economy

© 2012 Pearson Education, Inc Publishing as Prentice Hall

Along the aggregate demand curve, each point represents:

a Equilibrium in the goods market, regardless of the equilibrium

situation in the money market

b Equilibrium in the money market, regardless of the

equilibrium situation in the goods market

c Simultaneous equilibrium in both the goods and money

markets.

d Macroeconomic equilibrium, or equilibrium in all markets of

the economy

 FIGURE 12.9 Factors That Shift the Aggregate Demand Curve

Shifts of the Aggregate Demand Curve from Policy Variables

The Aggregate Demand (AD) Curve