Aggregate Demand. Sherif Khalifa. Sherif Khalifa () Aggregate Demand 1 / 35

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1 Sherif Khalifa Sherif Khalifa () Aggregate Demand 1 / 35

2 The ISLM model allows us to build the AD curve. IS stands for investment and saving. The IS curve represents what is happening in the market for goods and services. LM stands for liquidity and money. The LM curve represents what is happening to the supply and demand for money. Sherif Khalifa () Aggregate Demand 2 / 35

3 An economy s total income is determined by the spending plans of households, firms, and the government. The more they want to spend, the more goods and services firms can sell. The more firms can sell, the more output they will choose to produce and the more workers they will choose to hire. Sherif Khalifa () Aggregate Demand 3 / 35

4 Keynesian Cross Definition Actual expenditure is the amount households, firms, and the government spend on goods and services. Definition Planned expenditure is the amount households, firms, and the government would like to spend on goods and services. The actual expenditure might be different than planned expenditure because firms might engage in unplanned inventory investment. When firms sell less of their product than planned, their stock of inventories increases. When firms sell more of their product than planned, their stock of inventories decreases. Actual expenditure can be either above or below planned expenditure. Sherif Khalifa () Aggregate Demand 4 / 35

5 Keynesian Cross AE = Y PE = C + I + G C = C (Y T ) I = I G = G T = T PE = C ( Y T ) + I + G Sherif Khalifa () Aggregate Demand 5 / 35

6 Keynesian Cross Expenditure Actual Expenditure Planned Expenditure Y 1 Output Sherif Khalifa () Aggregate Demand 6 / 35

7 Keynesian Cross If GDP is higher than the equilibrium level, planned expenditure is lower than production. Firms are selling less than they are producing, and add the unsold goods to their stock of inventories. This unplanned increase in inventories induces firms to lay off workers and decrease production. This process continues until income falls to the equilibrium level. If GDP is lower than the equilibrium level, planned expenditure is higher than production. Firms meet the higher level of sales by drawing down their inventories. When firms see their stock of inventories dwindle, they hire more workers and increase production. GDP increases and the economy approaches equilibrium. Sherif Khalifa () Aggregate Demand 7 / 35

8 Keynesian Cross Expenditure AE=Y PE 2 =C 1 +I 1 +G 2 PE 1 =C 1 +I 1 +G 1 Y 1 Y 2 Output Sherif Khalifa () Aggregate Demand 8 / 35

9 Definition The government spending multiplier tells us how much income increases due to a $1 increase in government spending. When an increase in government spending increases income, it also increases consumption, which further increases income. Initial Change = G First Change = (MPC ) G Second Change = (MPC ) 2 G Third Change = (MPC ) 3 G Sherif Khalifa () Aggregate Demand 9 / 35

10 Y = ( 1 + MPC + MPC 2 + MPC ) G Y G = ( 1 + MPC + MPC 2 + MPC ) Y G = 1 1 MPC MPC = 0.6 Y G = 1 1 MPC 1 = = 2.5 Sherif Khalifa () Aggregate Demand 10 / 35

11 Expenditure AE=Y PE 1 =C 1 +I 1 +G 1 PE 2 =C 2 +I 1 +G 1 Y 2 Y 1 Output Sherif Khalifa () Aggregate Demand 11 / 35

12 Definition The taxes multiplier tells us how much income increases due to a $1 decrease in taxes. Y = ( 1 + MPC + MPC 2 + MPC ) ( MPC ) T Y T = ( 1 + MPC + MPC 2 + MPC ) ( MPC ) Y T = MPC 1 MPC MPC = 0.6 Y T = = 1.5 Sherif Khalifa () Aggregate Demand 12 / 35

13 E AE PE 1 PE 2 r Y r Y 2 Y 1 r 2 r2 r 1 r1 I(r) IS I 2 I 1 I Y 2 Y 1 Y Sherif Khalifa () Aggregate Demand 13 / 35

14 The interest rate is the cost of borrowing to finance investment projects. An increase in the interest rate decreases investment spending. The reduction in planned investment shifts the planned expenditure function downward. This causes the level of income to decrease. Thus, an increase in the interest rate lowers income. Sherif Khalifa () Aggregate Demand 14 / 35

15 E AE PE 1 PE 2 r r Y 1 Y 2 Y r 1 r1 IS 2 I(r) IS 1 I 1 I Y 1 Y 2 Y Sherif Khalifa () Aggregate Demand 15 / 35

16 The IS curve is drawn for a given fiscal policy. Changes in fiscal policy that increase the demand for goods and services shift the IS curve to the right. Changes in fiscal policy that decrease the demand for goods and services shift the IS curve to the left. Sherif Khalifa () Aggregate Demand 16 / 35

17 Theory of Liquidity Preference ( ) M s = M P P ( ) M d = L (r, Y ) P Sherif Khalifa () Aggregate Demand 17 / 35

18 Theory of Liquidity Preference Money supply is an exogenous variable chosen by a central bank. The interest rate is the opportunity cost of holding money. It is what you forgo by holding some of your assets as money, instead of interest-bearing accounts. When the interest rate increases, people want to hold less of their wealth in the form of money. When income is high, expenditure is high, so people engage in more transactions that require the use of money. Sherif Khalifa () Aggregate Demand 18 / 35

19 Theory of Liquidity Preference r Money Supply r 1 Money Demand L(r,Y) M/P Sherif Khalifa () Aggregate Demand 19 / 35

20 Theory of Liquidity Preference If the interest rate is above the equilibrium level, the quantity of real money balances supplied exceeds the quantity demanded. Individuals holding the excess supply of money try to convert some of their non-interest bearing money into interest bearing accounts and bonds. Banks and bond issuers respond to this excess supply of money by lowering the interest rates they offer. If the interest rate is lower than the equilibrium level, the quantity of real money balances demanded exceeds the quantity supplied. Individuals try to obtain money by selling bonds or making bank accounts withdrawals. To attract news scarce funds, banks and bond issuers respond by increasing the interest rate they offer. Sherif Khalifa () Aggregate Demand 20 / 35

21 Theory of Liquidity Preference r MS 1 MS 2 r 1 r 2 MD 1 M/P Sherif Khalifa () Aggregate Demand 21 / 35

22 Theory of Liquidity Preference r MS 2 MS 1 r 2 r 1 MD 1 M/P Sherif Khalifa () Aggregate Demand 22 / 35

23 r MS 1 r LM r 2 r 2 r 1 r 1 MD 2 MD 1 M/P Y 1 Y 2 Y Sherif Khalifa () Aggregate Demand 23 / 35

24 Theory of Liquidity Preference If income increases, expenditure increases. The money demand curve shifts to the right. As the supply of real money balances is unchanged, the interest rate increases to equilibrate the money market. Higher income leads to a higher interest rate. Sherif Khalifa () Aggregate Demand 24 / 35

25 r MS 2 MS 1 r LM2 LM1 r 2 r 2 r 1 r 1 MD 1 M/P Y 1 Y Sherif Khalifa () Aggregate Demand 25 / 35

26 Theory of Liquidity Preference The LM curve is drawn for a given supply of real money balances. Decreases in the supply of real money balances shift the LM curve upward. Increases in the supply of real money balances shift the LM curve downward. Sherif Khalifa () Aggregate Demand 26 / 35

27 r LM 1 r 1 IS 1 Y 1 Y Sherif Khalifa () Aggregate Demand 27 / 35

28 r LM 1 r 2 r 1 IS 2 Y 1 Y 2 IS 1 Y Sherif Khalifa () Aggregate Demand 28 / 35

29 When the government increases its purchases of goods and services, the economy s planned expenditure increases. The increase in planned expenditure stimulates the production of goods and services, which causes total income to increase. The increase in total income increases the quantity of money demanded at every interest rate. As the supply of money has not changed, higher money demand causes the interest rate to increase. When the interest rate increases, firms cut back on their investment plans. This decrease in investment partially offsets the effect of the increase in government purchases. Sherif Khalifa () Aggregate Demand 29 / 35

30 r LM 1 LM 2 r 1 r 2 Y 1 Y 2 IS 1 Y Sherif Khalifa () Aggregate Demand 30 / 35

31 An increase in money supply leads to an increase in real money balances. People have more money than they want to hold at the prevailing interest rate. They start depositing this extra money in banks or using it to buy bonds. The interest rate then falls until people are willing to hold all the extra money. An increase in real money balances leads to a lower interest rate. A lower interest rate stimulates planned investment, which increases production and income. Sherif Khalifa () Aggregate Demand 31 / 35

32 r LM 2 LM 1 P P 2 P 1 IS 1 AD Y 2 Y 1 Y Y 2 Y 1 Y Sherif Khalifa () Aggregate Demand 32 / 35

33 For any given money supply, a higher price level decreases the supply of real money balances. A lower supply of real money balances, shifts the LM curve to the left This increases the equilibrium interest rate and lowers the equilibrium level of income. The aggregate demand curve plots the negative relationship between income and the price level. Sherif Khalifa () Aggregate Demand 33 / 35

34 r LM 1 P LM 2 P 1 AD 2 IS AD 1 Y 1 Y 2 Y Y 1 Y 2 Y Sherif Khalifa () Aggregate Demand 34 / 35

35 r LM 1 P IS2 P 1 AD 2 IS 1 AD 1 Y 1 Y 2 Y Y 1 Y 2 Y Sherif Khalifa () Aggregate Demand 35 / 35

Aggregate Demand. Sherif Khalifa. Sherif Khalifa () Aggregate Demand 1 / 36

Aggregate Demand. Sherif Khalifa. Sherif Khalifa () Aggregate Demand 1 / 36 Sherif Khalifa Sherif Khalifa () Aggregate Demand 1 / 36 The ISLM model allows us to build the Aggregate Demand curve. IS stands for investment and saving. The IS curve represents what is happening in