Chapter 11: Aggregate Demand II

1. Chapter 11: Aggregate Demand II

2. Fiscal Policy • Initial equilibrium: IS1 = LM1 with Y1 and r1 • Let G increase and/or T decrease • IS increases, resulting in Y2>Y1 • Crowding-out effect: As Y increases, demand for money rises, interest rate and income fall • Final equilibrium: IS2 = LM1 with Y3>Y2 and r2>r1

3. Fiscal Policy Interest Rate LM1 r2 r1 IS2 IS1 Y1 Y3 Y2 Income

4. Monetary Policy • Initial equilibrium: IS1 = LM1 with Y1 and r1 • Let M increase at constant P • LM increases, resulting in Y2>Y1 and r2<r1 • Crowding-out effect won’t take place because while income rises, interest rate falls

5. Monetary Policy Interest Rate LM1 LM2 r1 r2 IS1 Y1 Y2 Income

6. Policy Reaction 1 • Policy measure: concretionary fiscal • FED’s Reaction: none • Policy results: IS falls, reducing income and interest rate

7. Policy Reaction 1 Interest Rate LM1 r1 r2 IS1 IS2 Y2 Y1 Income

8. Policy Reaction 2 • Policy measure: concretionary fiscal • Policy results: IS falls, reducing Y and r • FED’s reaction: holding interest rate constant by decreasing the money supply, reducing Y and increasing r • Policy results: sharp reduction in income at constant interest rate

9. Policy Interaction 2 Interest Rate LM2 LM1 r1 r2 IS1 IS2 Y3 Y2 Y1 Income

10. Policy Reaction 3 • Policy measure: concretionary fiscal • Policy results: IS falls, reducing Y and r • FEDs reaction: holding income constant by increasing the money supply, reducing r and increasing Y • Policy results: sharp reduction in interest rate at constant income

11. Policy Interaction 3 Interest Rate LM1 LM2 r1 r2 r3 IS1 IS2 Y2 Y1 Income

12. Expectations • Business outlook • Optimism: I and IS increase, resulting in higher Y but lower r • Pessimism: I and IS decrease, resulting in lower Y but higher r • Consumer confidence • Optimism: C and IS increase, resulting in higher Y but lower r • Pessimism: C and IS decrease, resulting in lower Y but higher r

13. Identifying Aggregate Demand • Initial equilibrium: IS1 = LM1 with Y1 and r1 • Let P increase, causing M/P to decline • LM decreases, resulting in Y2<Y1 and r2>r1 • As Y falls, demand for goods and services declines, resulting in a higher price • Lower Y, but higher P identifies the AD

14. Identifying Aggregate Demand Interest Rate Price LM2 LM1 B P2 r2 A P1 r1 AD IS2 Y2 Y1 Income Y2 Y1 Income

15. Monetary Policy • Initial equilibrium: IS1 = LM1 with Y1 and r1 • Let M increase, causing M/P to rise • LM increases, resulting in Y2>Y1 and r2<r1 • Increased Y at constant P indicates an increase in AD

16. Monetary Policy Interest Rate Price LM2 LM1 A B P r1 r2 AD2 AD1 IS2 Y1 Y2 Income Y1 Y2 Income

17. Fiscal Policy • Initial equilibrium: IS1 = LM1 with Y1 and r1 • Let G increase, causing IS to rise • An increase in IS result in Y2>Y1 and r2>r1 • Increased Y at constant P indicates an increase in AD

18. Fiscal Policy Interest Rate Price LM1 r2 A B P r1 IS2 AD1 IS1 AD2 Y1 Y2 Income Y1 Y2 Income

19. Long-run Equilibrium • Initial equilibrium: IS1 = LM1 with Y1 and r1, but Y1<Y indicates insufficient expenditures in the economy • Insufficient AD results in a lower P, causing M/P to rise • Both LM and SRAS increase, increasing Y1 toward Y • Long-run equilibrium is at the intersection of LRAS and AD

20. Increase in Aggregate Demand Interest Rate Price LRAS LRAS LM1 LM2 SRAS1 P1 SRAS2 P2 r1 r2 IS2 AD1 IS1 AD2 Y1 Y Income Y1 Y Income

21. Reasons for The Great Depression • Spending hypothesis: IS declined sharply • The Stock Market crash reduced consumer wealth and spending • Decline in immigration reduced the demand for residential investment • Business pessimism caused bank failure • The government increased the rate of income taxation

22. Reasons for The Great Depression • Monetary hypothesis: LM declined sharply • Price deflation due to reduced Aggregate Demand • Tight monetary policy as the FED increased the discount rate to halt gold outflow • The fall in the real interest rate reduced the speculative demand for money