CH 12

PRINCIPLES OF
MACROECONOMICS
TENTH EDITION
PART III The Core of Macroeconomic Theory
CASE FAIR OSTER

© 2012 Pearson Education, Inc. Publishing as Prentice Hall Prepared by: Fernando Quijano & Shelly
1 ofTefft
39
© 2012 Pearson Education, Inc. Publishing as Prentice Hall 2 of 39

Aggregate Demand in
the Goods and Money 12
Markets
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
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.

 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.

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.

ECONOMICS IN PRACTICE
Small Business and the Credit Crunch
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
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


 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.
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.

Using a convenient shorthand:
r  I  AE  Y 
r  I  AE  Y 

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.
We can thus write:

Y  M  r  d
Y  M  r  d

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.

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).

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.


 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.


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
lessthanif r didnotincrease

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
lessthanif M didnotincrease

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  orT  Y  M d  r  I 
Y decreases
lessthanif r didnotdecrease

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
lessthanif M didnotdecrease

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

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
Contractionary
Y ?, r , I , C ? Y , r ?, I ?, C 
( M s )
Key:
: Variable
increases.
: Variable
decreases.
? : Forcespushthevariable
indifferent
directions
. Without
additional
informatio
n,wecannot
specify whichwaythevariable
moves.
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.

 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.

 FIGURE 12.6 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 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.

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 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 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.

 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.

 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.


 FIGURE 12.9 Factors That Shift the Aggregate Demand Curve

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.
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.

REVIEW TERMS AND CONCEPTS
aggregate demand (AD) curve
contractionary fiscal policy
contractionary monetary policy
crowding-out effect
expansionary fiscal policy
expansionary monetary policy
goods market
interest sensitivity or insensitivity of planned investment
money market
policy mix
real wealth, or real balance, effect

CHAPTER 12 APPENDIX
The IS-LM Model
The IS Curve
 FIGURE 12A.1 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.

CHAPTER 12 APPENDIX
The IS-LM Model
The LM Curve
 FIGURE 12A.2 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.

CHAPTER 12 APPENDIX
The IS-LM Model
The IS-LM Diagram
 FIGURE 12A.3 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.

CHAPTER 12 APPENDIX
The IS-LM Model
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.
CHAPTER 12 APPENDIX
The IS-LM Model
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.
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.
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.

APPENDIX REVIEW TERMS AND CONCEPTS
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.

CH 12

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PRINCIPLES OF

CASE FAIR OSTER

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 2 of 39

Contractionary Policy Effects

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 3 of 39

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 4 of 39

 FIGURE 12.1 Planned Investment Schedule

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 of 39

Other Determinants of Planned Investment

The assumption that planned investment depends only on the interest

In practice, the decision of a firm on how much to invest depends on,

The optimism or pessimism of entrepreneurs about the future course

Keynes used the phrase animal spirits to describe the feelings of

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 6 of 39

Small Business and the Credit Crunch

We know how a firm’s

investing, not by high

Planned Aggregate Expenditure and the Interest Rate

Recall that planned aggregate expenditure is the sum of consumption,

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 8 of 39

Planned Aggregate Expenditure 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

Finally, a decrease in planned aggregate expenditure lowers

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 10 of 39

Planned Aggregate Expenditure and the Interest Rate

Using a convenient shorthand:

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 11 of 39

We can thus write:

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 12 of 39

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 13 of 39

Expansionary Policy Effects

expansionary fiscal policy An increase in government

expansionary monetary policy An increase in the money

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 14 of 39

Expansionary Policy Effects

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

crowding-out effect The tendency for

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 15 of 39

Expansionary Policy Effects

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

 FIGURE 12.4 The Crowding-Out

The crowding-out effect of the

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 16 of 39

Expansionary Policy Effects

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

interest sensitivity or insensitivity of planned investment The

planned investment as a result of changes in the interest rate.

Effects of an expansionary fiscal policy:

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 17 of 39

Expansionary Policy Effects

Expansionary Monetary Policy: An Increase in the Money Supply

Effects of an expansionary monetary policy:

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 18 of 39

Contractionary Policy Effects

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

contractionary fiscal policy A decrease in

Effects of a contractionary fiscal policy:

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 19 of 39

Contractionary Policy Effects