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

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 r2

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 Y2

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 r2

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 Y1

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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