Principles of Macroeconomics
Principles of Macroeconomics ECON 102
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This 5 page Class Notes was uploaded by Miracle Muller MD on Thursday October 29, 2015. The Class Notes belongs to ECON 102 at Wellesley College taught by Akila Weerapana in Fall. Since its upload, it has received 14 views. For similar materials see /class/230948/econ-102-wellesley-college in Economcs at Wellesley College.
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Date Created: 10/29/15
Fall Semester 39013902 Akila Weerapana Lecture 13 The Aggregate Demand Curve I OVERVIEW p r p r According to the Keynesian Cross model the government can have a magni ed impact on the economy by increasing purchases in reality however government purchases are not a guaranteed way to raise GDP To better understand the real world we need to use a richer model that describes how the economy behaves The model we use will be called the Aggregate DemandPrice Adjustment model it builds on the concepts of the Keynesian cross model but is much more useful for analyzing policy decisions This model has two components an Aggregate Demand curve and a Price Adjustment line Today we will look at the Aggregate Demand curve and in the next lecture study the Price Adjustment line THE RELATIONSIHP BETWEEN GDP AND THE INTEREST RATE The Aggregate Demand curve describes a relationship between GDP and in ation We derive the relationship in two steps first the relationship between the interest rate and GDP and then the relationship between in ation and the interest rate The first part of the relationship between the interest rate and output draws on a modi ed version of the Keynesian Cross model It resembles the Keynesian Cross model in that increases in spending have a magni ed impact on output through the multiplier It differs from the Keynesian Cross in that it incorporates explicitly the relationship between the interest rate and GDP Consumption 0 As in the Keynesian Cross increases in consumer con dence and decreases in taxes are assumed to increase consumption and vice versa 0 In addition increases in interest rates are assumed to reduce consumption albeit insigni cantly and vice versa An increase in interest rates will reduce consumption by making it more attractive for some people to save but will make it more attractive for others who have a lot of savings already to consume Investment 0 There is a negative relationship between interest rates and investment Higher interest rates make it expensive to borrow and also increase the opportunity cost of using ones own funds 0 Investment will also change for reasons unrelated to interest rates These other factors are what Keynes termed animal spirits changes unrelated to r but due to investor con dence for example Net Exports 0 There is a negative relationship between interest rates and NX Higher interest rates make it more attractive for foreigners to leave their money here which in turn causes the currency to increase in value 0 The rise in the value of the currency makes it cheaper to buy foreign goods and reduces NX o NX can also change for other reasons If foreigners develop a taste for domestic goods then NX can increase for example 0 So the end result is a negative relationship between r and Y working through the channels of C I and NX r Y III THE RELATIONSIHP BETWEEN INFLATION AND THE INTEREST RATE 0 The second part of the Aggregate Demand curve is the relationship between in ation and the real interest rate This relationship is based on the actions of the Federal Reserve which typically responds to increases in in ation by raising the interest rate and to decreases in in ation by lowering interest rates This relationship between in ation and the interest rate can be summarized by what s called a monetary policy rule the interest rate can be expressed as a systematic function of the rate of in ation The relationship can be described graphically as follows Note that unlike the textbook we have not made and will not make a distinction between real and nominal interest rates What I have called ie interest rate is the real interest rate in the economy The subsequent analysis differs slightly from the textbook which presents the monetary policy rule in terms of nominal interest rates IV THE AGGREGATE DEMAND CURVE 0 We now have the two relationships the negative relationship between GDP and the interest rate and the positive relationship between in ation and the interest rate Combining these two relationships establishes a negative relationship between in ation and GDP r r TE L Y L 7 Y 0 When in ation is high the Federal Reserve will raise interest rates in an attempt to lower in ation by slowing down GDP The increase in interest rates will lower spending which in turn will reduce output through the multiplier effect So an increase in in ation will reduce GDP 0 Conversely when in ation is low the Fed will lower interest rates The resulting low interest rate will raise spending The increase in spending will increase output through the multiplier effect So a fall in in ation will increase GDP 0 So we will end up with a negative relationship between in ation and GDP which we call the Aggregate Demand curve Inflation Rate IV WHAT CAUSES THE AD CURVE TO SPHFT 0 Key Changes in GDP brought about through changes in in ation are re ected as movements along the AD curve and not as shifts in the AD curve 0 What causes the AD curve to shift Any increase in spending will increase output through the multiplier effect This increase will occur regardless of the in ation rate in the economy therefore it will cause the AD curve to shift out 0 So the AD curve will shift out for any of the following reasons 1 An increase in government purchases G or a reduction in taxes T 2 An increase in consumer con dence 3 An increase in investor con dence 4 Foreigners develop a taste for US goods or US residents lose their taste for foreign goods 0 Conversely any decrease in spending will decrease output through the multiplier effect at every level of in ation So the AD curve will shift inwards 0 So the AD curve will shift in for any of the following reasons 1 A decrease in government purchases G or an increase in taxes T 2 A decrease in consumer con dence 3 A decrease in investor con dence 4 Foreigners lose their taste for US goods or US residents develop a taste for foreign goods 0 Monetary policy changes by the Federal Reserve also affect the AD curve If the Fed changes interest rates IN RESPONSE to changes in in ation that will be a movement along the AD curve rather than a shift in the AD curve However sometimes the Fed will change interest rates WITHOUT any change in current in ation to ward off future in ation for example Such decisions will shift the AD curve 0 So a decision to lower interest rates today WITHOUT a change in in ation expansionary monetary policy will raise spending and shift the AD curve out A decision to raise interest rates WITHOUT a change in in ation contractionary monetary policy will lower spending and shift the AD curve in Inflation Rate Inflation Rate gt 4 DP GDP EXPANSIONARY POLICY CONTRACTIONARY POLICY 0 Intuition At the current rate of in ation interest rates will be lower under expansionary policy This fall in interest rates means that spending will be higher and therefore output will be higher as well Conversely contractionary policy will cause interest rates to rise at the existing level of in ation The rise in interest rates will lower investment and reduce GDP This is re ected as a shift in of the AD curve EXAMPLE 1 AN INCREASE IN GOVERNMENT PURCHASES 0 An increase in G will cause GDP to increase at every level of in ation This will cause the AD curve to shift out The magnitude of the shift out is determined by the size of the multiplier EXAMPLE 2 A FALL IN INVESTOR CONFIDENCE 0 Conversely a decrease in investor con dence will cause GDP to decrease at every level of in ation This will cause the AD curve to shift in the magnitude of the shift is also determined by the size of the multiplier Inflation Example 1 gt AD AD Inflation Example 2 AD AD F GDP
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