15-01-2021

Aggregate Demand
in the Goods and
Money Markets

By Vishwa Ballabh

Aggregate Demand in the Goods and Money Markets

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.

1
 15-01-2021

Planned Investment and the Interest Rate

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.

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. 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.

2
 15-01-2021

Planned Investment and the Interest Rate

Other Determinants of Planned Investment

Interest Rates and

Investment Spending

A recent study by Simon

Gilchrist, Fabio Natalucci,
and Egon Zakrajsek finds
that interest rates have a
powerful effect on the
behavior of firms.

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.

Recall that planned aggregate expenditure is the sum of consumption,

planned investment, and government purchases.

AE ≡ C + I + G

3
 15-01-2021

Government Deficit Displaces Private Capital

Planned Investment and the Interest Rate

Planned Aggregate Expenditure and the Interest Rate

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.

4
 15-01-2021

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

Using a convenient shorthand:

r  I  AE  Y 

r  I  AE  Y 

5
 15-01-2021

Equilibrium in Both the Goods and Money Markets

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:

Y  M d  r 
Y  M d  r 

Equilibrium in Both the Goods and Money Markets

Links Between the Goods Market and the Money Market

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

6
 15-01-2021

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).

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

Expansionary Fiscal Policy: An Increase in Government

Purchases (G) or a Decrease in Net Taxes (T)

crowding-out effect The tendency for increases

in government spending to cause reductions in
private investment spending.

7
 15-01-2021

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)

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.

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)

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 increases less than if r did not increase

8
 15-01-2021

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:

M s  r  I  Y  M d 
d
r decreases less than if M did not increase

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)

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 decreases less than if r did not decrease

9
 15-01-2021

Policy Effects in the Goods and Money Markets

Contractionary Policy Effects
Contractionary Monetary Policy: A Decrease in the
Money Supply

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 
d
r increases less than if M did not decrease

Policy MIX

Expansionary Fiscal Policy with Expansionary Monetary Policy

G↑orT

10
 15-01-2021

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 27.1 The Effects of the Macroeconomic Policy Mix

Fiscal Policy
Expansiona ry Contractio nary
( G or  T ) ( G or  T )
Expansiona ry
Y , r ?, I ?, C  Y ?, r , I , C ?
( M s )
Monetary
Policy
Contractio nary
Y ?, r , I , C ? Y , r ?, I ?, C 
( M s )
Key :
: Variable increases.
: Variable decreases.
? : Forces push the variable in different directions. Without additional information, we cannot
specify which way the variable moves.

The Aggregate Demand (AD) Curve

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.

11
 15-01-2021

The Aggregate Demand (AD) Curve

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.

12
 15-01-2021

The Aggregate Demand (AD) Curve

The Aggregate Demand (AD) Curve

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.

The Aggregate Demand (AD) Curve

The Aggregate Demand Curve: A Warning

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.

13
 15-01-2021

The Aggregate Demand (AD) Curve

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).

The Aggregate Demand (AD) Curve

Other Reasons for a Downward-Sloping Aggregate Demand Curve

The Consumption Link

The initial decrease in consumption (brought about

by the increase in the interest rate) contributes to
the overall decrease in output.

Planned investment does not bear all the burden

of providing the link from a higher interest rate to a
lower level of aggregate output.

Decreased consumption brought about by a higher

interest rate also contributes to this effect.

14
 15-01-2021

The Aggregate Demand (AD) Curve

Other Reasons for a Downward-Sloping Aggregate Demand Curve
The Real Wealth Effect

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.

The Aggregate Demand (AD) Curve

Aggregate Expenditure and Aggregate Demand

At equilibrium, planned aggregate expenditure

(AE ≡ C + I + G) and aggregate output (Y) are equal:

equilibrium condition: C + I + G = Y

15
 15-01-2021

The Aggregate Demand (AD) Curve

Shifts of the Aggregate Demand Curve

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.

The Aggregate Demand (AD) Curve

Shifts of the Aggregate Demand Curve

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.

16
 15-01-2021

The Aggregate Demand (AD) Curve

Shifts of the Aggregate Demand Curve

Factors That Shift the Aggregate Demand Curve

APPENDIX A
THE IS-LM DIAGRAM
THE IS 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.

The IS Curve
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.

17
 15-01-2021

APPENDIX A
THE IS-LM DIAGRAM
THE LM CURVE

An LM curve illustrates the positive relationship between

the equilibrium value of the interest rate and aggregate
output (income) (Y) in the money market.

The LM Curve

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.

APPENDIX A
THE IS-LM DIAGRAM
THE IS-LM DIAGRAM

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 IS-LM Diagram

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.

18
 15-01-2021

APPENDIX A
THE IS-LM DIAGRAM
THE IS-LM DIAGRAM

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.

APPENDIX A
THE IS-LM DIAGRAM
THE IS-LM DIAGRAM

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.

19
 15-01-2021

T = t0 + t1Y

G =g0 - g1Y

Public sector deficit and national income

Sustainable Debt

Debt is sustainable if D/Y is not changing. A change in the ratio of debt to GDP can result
from three factors;

1. It rises because of interest on existing debt. This adds r (D/Y) to the debt to GDP ratio.
2. It falls because of growth of GDP . This reduces the debt to GDP ratio by g(D/Y)
3. Finally, debt change by the size of the primary deficit relative to GDP.

Putting these three categories se have;

Change in D/Y = (r - g)D/Y + Primary Deficit/ GDP

Therefore the debt/GDP ratio is constant when:

(r - g)D/Y = Primary Deficit/ GDP

20
 15-01-2021

Thank You!

21