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1.3 Aggregate demand and supply
Advanced Macroeconomics
43
Introduction to Macroeconomics
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Figure.1.12 Effects of monetary policies on the IS-LM model
A monetary policy, by reducing the interest rate, always improves the income of people. The reduction in the interest rate helps increase investments in the economy. Figure 1.12 shows that the monetary authority reduces the interest rate, and so, I declines to I1. The level of income increases from Y to Y1. But in the long run, the reduction in the interest rate and the increase in incomes lead to more investments.
Production increases due to higher capital investments. But higher production could also lead to lower demand, and to prices declining. This is because every firm tries to sell their products in the national and international markets. They may sell at lower prices just to cover the fixed costs of production. The decline in prices due to competition reduces the profit margin. The investments made and profits gained do not match. Future investments are affected. A recession occurs. A decline in investments reduces the employment opportunities, which reduces the income levels. Incomes decline further and go back to the original level. In the long run, an expansionary monetary policy is ineffective. The interest rate (I) and incomes (Y) remain unaffected in the long run.
1.2.8 Conclusion
The goods market is in equilibrium when the demand for goods and services equals the supply of goods and services. Prices are constant. The money market is in equilibrium when the demand for money equals the supply of money. Both the goods and money markets are in equilibrium with the interest rate and income. Expansionary fiscal and monetary policies lead to increases and decreases in the interest rate and incomes, but only in the short term. In the long term, both monetary and fiscal policies are ineffective.
Advanced Macroeconomics
44
Introduction to Macroeconomics
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Figure 1.13 Derivation of aggregate demand
Figure 1.13 shows that the IS-LM curves are intersecting at Point E. When the IS curve shifts to IS1, perhaps because of an expansionary fiscal policy, the new equilibrium point is observed at E1. In the second diagram, if points a and b are joined, the aggregate demand curve can be derived.
1.3.1 Effects of monetary expansion on the aggregate demand
The aggregate demand (AD) curve is affected by an expansionary monetary policy. The rise in the money supply and decline in interest rates affect income and output, increasing them. Figure 1.14 shows an expansionary monetary policy’s effects on aggregate demand.
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1.3.1 Effects of monetary expansion on the aggregate demand
The aggregate demand (AD) curve is affected by an expansionary monetary policy. The rise in the money supply and decline in interest rates affect income and output, increasing them. Figure 1.14 shows an expansionary monetary policy’s effects on aggregate demand.
Figure 1.14 Effects of monetary policies on the aggregate demand
I LM1
E LM
Interest I E1
I1
Prices b
P a AD1 AD
Y Y1 Y Income
Figure 1.14 indicates that the expansionary monetary policy will have a positive effect on income and output. The interest rate will fall from i to i1. The LM curve shifts from LM to LM1. An expansionary monetary policy will have no effect on the price level. Prices will remain at equilibrium at P. If we join the two points a and b, the AD curve can be derived.
Figure 1.14 Effects of monetary policies on the aggregate demand
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Advanced Macroeconomics
45
Introduction to Macroeconomics Figure 1.14 indicates that the expansionary monetary policy will have a positive effect on income and output. The interest rate will fall from i to i1. The LM curve shifts from LM to LM1. An expansionary monetary policy will have no effect on the price level. Prices will remain at equilibrium at P. If we join the two points a and b, the AD curve can be derived.
1.3.2 Shifts of the aggregate demand curve
The aggregate demand (AD) curve shifts towards the right, if there is an expansionary fiscal policy.
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Figure 1.15 Fiscal policies and shifts of the aggregate demand
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axa_ad_grad_prog_170x115.indd 1 19/12/13 16:36
Advanced Macroeconomics
46
Introduction to Macroeconomics In figure 1.15, the expansionary fiscal policy has positive effects on the aggregate demand, leading to an increase in income together with a large increase in the interest rate. The downward sloping supply curve is the aggregate demand curve.
1.3.3 The aggregate supply curve
The aggregate supply curve (ASC) is classified into two types: the Keynesian and the Classical aggregate supply curves, which are based on different assumptions. The classical supply curve assumes that the supply of the factor of production is fixed in the classical way. The supply of land, labor, and capital is fixed in an economy and does not change.
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D &ODVVLFDODJJUHJDWHVXSSO\FXUYH E.H\QHVLDQDJJUHJDWHVXSSO\FXUYH Figure 1.16 The Classical and Keynesian aggregate supply curves
Figure 1.16 shows the Classical and Keynesian aggregate supply curves. In a, the aggregate supply (AS) curve is a vertical straight line but in b, it is a horizontal line. In the Classical case, all the factors of production in the economy are fully employed. Therefore, there is no scope to increase the factors of production. The supply remains fixed for the long period.
1.3.4 The effects of monetary and fiscal policies on the classical aggregate supply curve A. Fiscal policy and the aggregate supply curve
An expansionary fiscal policy will shift the IS curve upwards without changing output.
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Figure 1.17 The effect of fiscal policies on the classical aggregate supply curve
Advanced Macroeconomics
47
Introduction to Macroeconomics Figure 1.17 represents the effect of fiscal policy on the classical aggregate supply curve. It shifts upwards, leading to an increase in the interest rate, I to I1. Income remains the same in the long run. In the long run, the effect on income is not positive.