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Intermediate macroeconomics chapt11

Chapter 11:
Aggregate Demand II


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


Fiscal Policy
Interest Rate

LM1

r2
r1
IS2

IS1
Y1

Y3 Y2

Income


Monetary Policy
Initial equilibrium: IS1 = LM1 with Y1 and r1
Let M increase at constant P
LM increases, resulting in Y2>Y1 and r2Crowding-out effect won’t take place because while
income rises, interest rate falls


Monetary Policy
Interest Rate

LM1
LM2

r1
r2
IS1
Y1

Y2

Income


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


Policy Reaction 1
Interest Rate


LM1

r1
r2
IS1
IS2
Y2

Y1

Income


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


Policy Interaction 2
Interest Rate

LM2
LM1

r1
r2
IS1
IS2
Y3 Y 2

Y1

Income


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


Policy Interaction 3
Interest Rate

LM1
LM2
r1
r2
r3
IS1
IS2
Y2

Y1

Income


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


Identifying Aggregate Demand
Initial equilibrium: IS1 = LM1 with Y1 and r1
Let P increase, causing M/P to decline
LM decreases, resulting in Y2r1
As Y falls, demand for goods and services declines, resulting in a
higher price
Lower Y, but higher P identifies the AD


Identifying Aggregate Demand
Interest Rate

Price
LM2
LM1
P2
P1

r2

B
A

r1

AD

IS2
Y2 Y1

Income

Y2 Y1

Income


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 r2Increased Y at constant P indicates an increase in AD


Monetary Policy
Interest Rate

Price
LM2
LM1
P

r1

A

B

r2
AD2
AD1

IS2
Y1 Y2

Income

Y1 Y2

Income


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


Fiscal Policy
Interest Rate

Price
LM1

r2

P

A

B

r1
IS2

AD1

IS1
Y1 Y2

Income

Y1

Y2 Income

AD2


Long-run Equilibrium
Initial equilibrium: IS1 = LM1 with Y1 and r1, but Y1indicates 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


Increase in Aggregate Demand
Interest Rate

Price

LRAS

LRAS

LM1
LM2
SRAS1

P1
P2

SRAS2

r1
r2
IS2

AD1

IS1
Y1 Y

Income

Y1

Y

Income

AD2


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


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



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