LESSON 8

LESSON 8
AGGREGATE DEMAND &

AGGREGATE SUPPLY
Lecture: Trinh Thu Thuy

School of Economics & Management (SEM)
Hanoi University of Science & Technology (HUST)
2020
1
So far, we have learnt….
 Growth of productivity & real GDP.

 Financial system works, real interest rate  balance
saving and investment.
 Unemployment in the economy.
 Monetary system, money supply  price level, inflation
rate, and nominal interest rate.
2
Macroeconomics – Lesson 8
Short run economic fluctuation

1 Business circle
Model of Aggregate Demand &

2 Aggregate Supply
3 The Influence of Monetary & Fiscal

Policy on Aggregate Demand
3 3
Aggregate Demand & Aggregate Supply
Chapter Objectives

Economic fluctuation

Business circle

Aggregate demand

Aggregate supply

Model of aggregate demand and aggregate supply

Short run & Long run equilibrium

Monetary & Fiscal policies (Public policies)
4

1 Business circle
5 5
Economic fluctuations
 Economic activity fluctuates over time
 Short run fluctuations  Business circle
 Economic activity
 Occur in all countries
 Properties of short run fluctuations:
 Irregular & Unpredictable
 Most macroeconomic quantities fluctuate together
o Income, investment, production, unemployment, spending,
sales etc.
 Output falls  unemployment rises
6
Economic Fluctuations
What is the trend or
Relationship b/w:
Growth
Inflation
Unemployment
Economic activity
fluctuates over time
Short run fluctuations
 Business circle
7
Economic Fluctuations
Recession: a period
of declining real
incomes and rising
unemployment
Depression: a severe
recession
8

1 Business circle

2 Aggregate Supply
9 9
Model of aggregate demand & aggregate supply

AD – AS model

Explain short-run
fluctuations in economic
activity around its long-
run trend

Real GDP: economy’s
output of goods and
services

Average level of prices
P: CPI or the GDP
deflator.
10
Concepts
 Aggregate-demand (AD)
The quantity of goods and services that households,
firms, the government, and customers abroad want to
buy at each price level
AD = C + I + G + X - M
 Aggregate-supply (AS)
The quantity of goods and services that firms choose
to produce and sell at each price level
AS  GDP = C + I + G + X – M
 Aggregate demand curve & Aggregate supply
curve
11
 Aggregate demand curve

shows the quantity of goods
and services that households,
firms, the government, and
customers abroad want to buy
at each price level
 Aggregate-supply curve
and services that firms
choose to produce and sell at
each price level
12
Aggregate demand curve & Aggregate supply curve
Aggregate demand curve

and services that households,
firms, the government, and
customers abroad want to buy
at each price level
Aggregate supply curve

and services that firms choose
to produce and sell at each
price level
Price level – CPI real GDP— total quantity of goods and

or GDP deflator services produced by all firms in all
markets. 13
 How does the economy’s behavior in the short run differ

from its behavior in the long run?
 Draw the model of aggregate demand and aggregate
supply. What variables are on the two axes?
14
THE AGGREGATE-DEMAND CURVE

 The aggregate-demand curve
shows the quantity of all goods
and services demanded in the
economy at any given price level.
 AD: downward sloping
 P & Q: negative relationship

The downward-sloping AD
curve assume that the money
supply is fixed.

The AD curve is drawn for a
given quantity of the money
supply.
15
AD curve – downward sloping

Three reasons for the negative relationship b/w P & Q:
 The Price Level and Consumption: The Wealth Effect
Price level falls (P)  real wealth rises  consumption
increases (C)  Q increases (demand for consumption goods)
 The Price Level and Investment: The Interest-Rate
Effect
Price level falls (P)  interest rates fall (r)  investment
increases (I)  Q increases (demand for investment goods)
 The Price Level and Net Exports: The Exchange-Rate
Effect
Price level falls (P)  exchange rate depreciates (EX)  net
export increases (NX)  Q increases (demand for net export)
 the real exchange rate - the relative price of domestic and
foreign goods. 16
Shift in AD curve
P
AD = C + I + G + NX AD
AD’
 Changes in Consumption
 Changes in Investment
 Changes in Government AD’’
Purchases
 Changes in Net Exports
17
 Explain the three reasons the aggregate-demand curve

slopes downward.
 Give an example of an event that would shift the
aggregate-demand curve. Which way would this event
shift the curve?
18
THE AGGREGATE-SUPPLY CURVE

 The aggregate-supply curve LAS
shows the total quantity of P SAS
goods and services that firms
produce and sell at any given
price level.
 The aggregate-supply curve
shows a relationship that
depends crucially on the time Potential
output or Full
horizon examined. employment
 In the long run: the output
aggregate-supply curve is Y
vertical. Y*
 In the short run: the (Natural rate of output)
aggregate-supply curve is U*
upward sloping (Natural unemployment) 19
Aggregate Supply Curve
LAS CURVE
LAS
Natural rate of output: the
production of goods and
services that an economy
achieves in the long run
when unemployment is at
its normal rate
Potential output or
full-employment output Y*
Y = f (K, L, R, T) = Y*
The Long-Run Aggregate - Supply Curve: The quantity of output supplied

 Depends on the economy’s quantities of labor, capital, and natural resources and
on the technology for turning these inputs into output (real variables).
 Does not depend on the overall price level  the long-run aggregate supply
curve is vertical at the natural rate of output.
20
SHIFT IN THE LAS CURVE

LAS
 Changes in labor P
 Changes in capital SAS
 Changes in natural resources

 Changes in technological
Knowledge
SHIFT IN THE SAS CURVE
 Changes in labor
 Changes in capital
Y
 Changes in natural resources Y*
 Changes in technological (Potential output)
knowledge U*
(Natural unemployment)
 Change in expected price
21
Aggregate Supply
22
Aggregate Demand & Aggregate Supply Model
Long-Run Growth and Inflation in the Model of

Aggregate Demand and Aggregate Supply
23
SAS CURVE
 SAS upward sloping
 P & Q: positive relationship
(only temporary)
The reasons SAS upward

sloping:
 Sticky wages
 Sticky prices
 Misperceptions
24
SAS Upward Sloping
(i) The Stick-Wage Theory

 Wages are “sticky” in the short run.
 Nominal wages are slow to adjust to changing
economic conditions
 Long-term contracts, nominal wages are fixed
 slowly changing social norms and notions of fairness that
influence wage setting.
 Nominal wages are based on expected prices do not respond
immediately when the actual price level is different from what
was expected.
 Firm produces less output when the price level is lower than
expected
 Firm produce more when the price level is higher than expected.
 The sticky-wage theory emphasizes that nominal wages
adjust slowly over time.
25
SAS Upward Sloping
(ii) The Sticky-Price Theory

 Prices of some goods and services also adjust
sluggishly in response to changing economic
conditions.
 Menu costs
 The cost of printing and distributing catalogs and the
time required to change price tags.
 As a result of menu costs, prices as well as wages may
be sticky in the short run.
26
SAS Upward Sloping
(iii) The Misperceptions Theory about relative price

 Misunderstand between overall price level and relative
prices.
 Relative price: price of goods compares to other prices
 changes in the overall price level can temporarily mislead suppliers
about what is happening in the individual markets in which they sell their
output  short-run misperceptions
 Misperceptions arise when the price level is above what was
expected.
 Suppliers of goods and services may notice the price of their output
rising and infer, mistakenly, that their relative prices are rising  they
respond to the higher price level by increasing the quantity of goods and
services supplied.
27
SAS Upward Sloping
Summing up
Three alternative explanations for the upward slope of the short-
run aggregate-supply curve: (1) sticky wages, (2) sticky prices,
and (3) misperceptions about relative prices.
a is a number that determines how much output responds to

unexpected changes in the price level.
 Sticky wages, sticky prices, or misperceptions conditions
are likely to be temporary  will not persist forever.
 Over time, nominal wages will become unstuck, prices will
become unstuck, and misperceptions about relative prices
will be corrected.
28
Real GDP
increases when
aggregate demand
rises
29
SAS Upward Sloping
SHORT-RUN AGGREGATE-SUPPLY CURVE MIGHT

SHIFT
 An increase in the expected P SAS’’ SAS
price level reduces the quantity SAS’
of goods and services supplied
and shifts the short-run
aggregate-supply curve to the
left.
 A decrease in the expected price
level raises the quantity of
goods and services supplied and
shifts the short-run aggregate-
supply curve to the right. Y
30
Supply Curve
Long run LAS

 In the long run, it is
reasonable to assume that
wages and prices are
flexible rather than sticky
and that people are not
confused about relative
prices
o Each of the three theories of short-run aggregate supply emphasizes a

problem that is likely to be temporary
o Sticky wages, sticky prices, or misperceptions conditions will not persist
forever.
o Over time, nominal wages will become unstuck, prices will become unstuck,
and misperceptions about relative prices will be corrected.
31
Common sense
LAS

P SAS
The quantity of output supplied
deviates from its long-run, or natural
level when the actual price level in the
economy deviates from the price level
that people expected to prevail.
 When the price level rises above the
level that people expected, output rises
above its natural rate.
 When the price level falls below the
expected level, output falls below its Y
Y*
natural rate.
(Natural rate of output)
U*
(Natural unemployment)
32
 WHY THE AGGREGATE-SUPPLY CURVE SLOPES

UPWARD IN THE SHORT RUN?
33
Quick Quiz
 Explain why the long-run aggregate-supply curve is
vertical?
 Explain three theories for why the short-run aggregate-
supply curve is upward sloping?
 What variables shift both the long-run and short-run
aggregate-supply curves?
 What variable shifts the short-run aggregate-supply
curve but not the long-run aggregate-supply curve?
34
35
TWO CAUSES OF ECONOMIC FLUCTUATIONS

LAS
 Shifts in aggregate demand P SAS’’ SAS
 To the right: P increases, Y SAS’
increases
 To the left: P decreases, Y
decreases
 Shifts in aggregate supply AD’
 To the right: P decreases, Q
increase

AD
To the left: P increase, Q
decrease AD’
Y
Y*
36
37
Four Steps for Analyzing Macroeconomic Fluctuations

1. Decide whether the event shifts the
aggregate demand curve or the
aggregate supply curve (or perhaps
both).
2. Decide in which direction the curve shifts.
3. Use the diagram of aggregate demand
and aggregate supply to determine the
impact on output and the price level in
the short run.
4. Use the diagram of aggregate demand
and aggregate supply to analyze how the
economy moves from its new short-run
equilibrium to its long-run equilibrium.
The Long Run Equilibrium
38
An analysis …..
39
Case study: TWO BIG SHIFTS IN AGGREGATE DEMAND:
THE GREAT DEPRESSION AND WORLD WAR II
40
THE EFFECTS OF A SHIFT IN AGGREGATE SUPPLY
Stagflation a period of falling output and rising prices 41

An analysis …..
42
Key concept
 recession
 depression
 model of aggregate demand and aggregate supply
 aggregate-demand curve
 aggregate-supply curve
 natural rate of output
 stagflation
43
44

1 Business circle

2 Aggregate Supply
3 The Influence of Monetary & Fiscal

Policy on Aggregate Demand
45 45
Aggregate demand: IS – LM model

 He criticized classical theory for assuming that
aggregate supply alone—capital, labor, and technology
—determines national income. Economists today
reconcile these two views with the model of aggregate
demand and aggregate supply.
 In the long run, prices are flexible, and aggregate sup-
ply determines income. But in the short run, prices are
sticky, so changes in aggregate demand influence
income.
46
Goods market and IS curve
Goods market
 Closed economy:
 Planned expenditure: PE = C + I + G (or AD)
 Planned expenditure is the amount households, firms, and the
government would like to spend on goods and services.
 Consumption function: C = C(Y − T)
 Disposable income (Y − T )
 I = I*
G = G*
 Y = T*
 PE = C(Y – T*) + I* + G*
Planned Expenditure as a Function of
Income
PE depends on income  higher income
leads to higher consumption - part of planned
expenditure. The slope of the planned-
expenditure function is the marginal
propensity to consume, MPC. 47
Goods market
The Economy in Equilibrium
The economy is in equilibrium when
Actual Expenditure = Planned Expenditure
Y = PE
C =C* + MPC (Y – T) = C* + MPC (1-t)Y; NT = tY
MPC: the marginal propensity to consume shows how much planned
expenditure increases when income rises by $1.
The equilibrium of this economy

is at point A, where the planned-
expenditure function crosses the
45-degree line.
The Keynesian Cross
The equilibrium in the Keynesian
cross is the point at which income
(actual expenditure) equals
planned expenditure (point A).
48
Goods market
In summary, the Keynesian cross

shows how income Y is determined
for given levels of planned
investment I and fiscal policy G
and T.
The Adjustment to
Equilibrium in the
Keynesian Cross
If Y1, then planned expenditure PE1 falls short of

production, and firms accumulate inventories.
This inventory accumulation induces firms to
decrease production. Similarly, if firms are
producing at level Y2, then planned expenditure
PE2 exceeds production, and firms run down their
inventories. This fall in inventories induces firms
to increase production. In both cases, the firms’
decisions drive the economy toward equilibrium.
49
Goods market
Fiscal Policy and the Multiplier:
Government Purchases
If government purchases rise by ∆G,
then the planned-expenditure schedule
shifts upward by ∆G
Government purchases multiplier:

How much income rises in response
to a $1 increase in government
purchases. An implication of the An Increase in Government Purchases in
Keynesian cross is that the the Keynesian Cross An increase in
government-purchases multiplier is government purchases of ∆G raises planned
expenditure by that amount for any given
larger than 1. level of income. The equilibrium moves
from point A to point B, and income rises
from Y1 to Y2. The increase in income ∆Y
exceeds the increase in government
purchases ∆G. Thus, fiscal policy has a
multiplied effect on income.
50
Goods market
Fiscal Policy and the Multiplier: Taxes

Changes in taxes affect equilibrium
income
A decrease in taxes of ∆T immediately
raises disposable income Y − T by ∆T,
therefore, increases consumption by
MPC × ∆T.
The overall effect on income of the
change in taxes is
∆Y/∆T = −MPC/(1 − MPC).
Tax multiplier: the amount
income changes in response to a $1
change in taxes.
51
IS curve
Interest rate, Investment and IS curve
 Interest rate and investment: I = I(r)
52
IS curve
 The IS curve shows the combinations of the interest rate

and the level of income that are consistent with equilibrium
in the market for goods and services.
 The IS curve is drawn for a given fiscal policy.
 Changes in fiscal policy that raise the demand for goods
and services shift the IS curve to the right.
 Changes in fiscal policy that reduce the demand for goods
and services shift the IS curve to the left.
53
IS curve
Fiscal policy shifts the IS curve
An Increase in Government
Purchases Shifts the IS Curve
Outward
an increase in government
purchases raises planned
expenditure. For any given
interest rate, the upward shift in
planned expenditure of ∆G leads
to an increase in income Y of
∆G/(1 − MPC)  the IS curve
shifts to the right by this amount.
54
Theory of liquidity preference

 John Maynard Keynes (1883 – 1946)
 The General Theory of Employment, Interest, and
Money (1936)
 Keynes’s theory that the interest rate adjusts to bring
money supply and money demand into balance
 Money market
 Money Supply
 Money Demand
 Equilibrium
55
Money market and LM curve
The Money Market and LM curve
The LM curve plots the relationship between the interest rate and the level of
income that arises in the market for money balances. To understand this
relationship, we begin by looking at a theory of the interest rate, called the
theory of liquidity preference.
The Theory of Liquidity Preference
In The General Theory, Keynes offered his view of how the interest rate is
determined in the short run.
The theory of liquidity preference: the interest rate adjusts to balance the
supply and demand for the economy’s most liquid asset—money.
M: the supply of money (issued by central bank or Federal Reserve 
exogenous policy variable
P: stands for the price level (in the short run, price is fixed  exogenous
variable)
M/P : supply of real money balances.
The theory of liquidity preference assumes there is a fixed supply of real
money balances,
56
Money market
The theory of liquidity preference: posits that the interest rate is
one determinant of how much money people choose to hold.
M1 = m.H
The interest rate is the opportunity cost of holding money H=C+R
MS /P
The Theory of Liquidity Preference
The supply and demand for real
money balances determine the
interest rate.
The supply curve for real money E
balances is vertical because the
supply does not depend on the
interest rate.
The demand curve is downward
sloping At the equilibrium interest rate, the
A higher interest rate raises the quantity of real money balances
cost of holding money and thus demanded equals the quantity
lowers the quantity demanded. supplied. 57
Money market
A Reduction in the Money

Supply in the Theory of Liquidity
Preference
If the price level is fixed, a
reduction in the money supply from
M1 to M2 reduces the supply of
real money balances.
The equilibrium interest rate
therefore rises from r1 to r2.
58
LM curve
Income, money demand and LM curve

The level of income affects the demand for money.
Income is higher  expenditure is high  people engage in more
transactions that require the use of money  greater income implies
greater money demand.
59
LM curve
Income, money demand and LM curve
Deriving the LM Curve Money market in equilibrium when:

The LM curve summarizing this (M/P)d = Ms /P
relationship between the interest rate Y – 50R = 3,000/4 = 750
and income: the higher the level of Y = 750 + 50R LM equation
income, the higher the interest rate. Y = f(R) 60
LM curve
Monetary Policies shift the LM curve
Reduction in the Money
Supply Shifts the LM
Curve Upward
For any given level of
income Y, a reduction in
the money supply raises
the interest rate that
equilibrates the money
market. Therefore, the
LM curve in panel shifts
upward.
The LM curve shows the combinations of the interest rate and the level of
income that are consistent with equilibrium in the market for real money
balances.
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.61
Nominal interest rate
(M/P) = Y – 50R
d
MS/P0
Ms = 3,000 R
P0 = 4 % E1
Money market in equilibrium E0
when: R0
(M/P)d = Ms /P
Y – 50R = 3,000/4 = 750 Md/P
 Y = 750 + 50R LM equation (Y0)
M /P MS/P M / P
0 d d
(Y2)Real money
Y1 increase
Y decrease
Yo  Ro
Y increase  R1 increase
Y decrease  R2 decrease
62
IS - LM model
Equilibrium in the IS–LM Model

The intersection of the IS and LM
curves represents simultaneous
equilibrium in the market for goods
E
and services and in the market for
real money balances for given values
of government spending, taxes, the
money supply, and the price level.
The IS–LM model. The two equations of this model:

Y = C(Y − T) + I(r) + G IS
M/P = L(r,Y) LM
IS x LM  equilibrium in both market
IS: Y = 1,200 – 40R (money market and good market)
LM: Y = 750 + 50R 1,200 – 40R = 750 + 50R
R* = 5%; Y* = 1,000
63
IS - LM model
Fiscal Policy Shift the IS Curve and Changes the
Short-Run Equilibrium
Changes in
Government
Purchase
The government-
purchases multiplier in
the Keynesian: change
in fiscal policy raises
the level of income at
any given interest rate
by ∆G/(1 − MPC). 64
IS - LM model
Changes in Taxes
The tax multiplier in
the Keynesian cross
tells us that this change
in policy raises the
level of income at any
given interest rate by
∆T × MPC/(1 − MPC )
65
IS - LM model
Monetary Policy Shift the LM Curve and Changes
the Short-Run Equilibrium
66
IS - LM model

67
IS - LM model
Conclusion
In the short run, when prices are sticky, an expansion in the
money supply raises income. But we did not discuss how a
monetary expansion induces greater spending on goods and
services—a process called the monetary transmission
mechanism.
The IS–LM model shows an important part of that mechanism:
an increase in the money supply lowers the interest rate, which
stimulates investment and thereby expands the demand for goods
and services.
68
IS - LM model
Interaction b/w fiscal and monetary policies
The Response of the Economy to a Tax
Increase
How the economy responds to a tax increase
depends on how the central bank
responds. In panel (a) the Fed holds the
money supply constant. In panel (b) the Fed
holds the interest rate constant by reducing
the money supply. In panel (c) the Fed holds
the level of income constant by raising the
money supply.
69
IS - LM model
The Theory of Short-Run Fluctuations

How the different pieces of the theory of short-run fluctuations fit together.
The Keynesian cross explains the IS curve.
The theory of liquidity preference explains the LM curve.
The IS and LM curves together yield the IS–LM model, which explains the aggregate
demand curve.
The aggregate demand curve is part of the model of aggregate supply and aggregate
demand, which economists use to explain short-run fluctuations in economic activity.
70
IS – LM model and AD curve
71
IS – LM Model and AD Curve

 The aggregate demand
curve shows the set of
equilibrium points that
arise in the IS–LM
model as we vary the
price level and see what
happens to income.
curve describes a
relationship between
the price level and the
level of national
income.
curve is downward
sloping.
72
AD curve and Policies
The Influence of Monetary and Fiscal Policy on

Aggregate Demand
 The aggregate-demand curve shows the total quantity of goods
and services demanded in the economy for any price level.
 The aggregate-demand curve slopes downward:
 Wealth effect
 The interest effect
 Exchange rate effect
 Monetary policy influences aggregate demand
 Fiscal policy influences aggregate demand
73
Aggregate Demand AD curve
AD curve – downward sloping

Three reasons for the negative relationship b/w P & Q:
 The Price Level and Consumption: The Wealth Effect
Price level P falls  real wealth rises  consumption C
increases  Q increases (demand for consumption goods)
 The Price Level and Investment: The Interest-Rate
Effect
Price level P falls  interest rates r fall  investment I
increases  Q increases (demand for investment goods)
 The Price Level and Net Exports: The Exchange-Rate
Effect
Price level P falls  exchange rate EX depreciates  net
export NX increases  Q increases (demand for net export)
 the real exchange rate - the relative price of domestic and
foreign goods. 74
Aggregate Demand
AD downward sloping

The wealth effect: A lower price level raises the real value of households’
money holdings (part of their wealth)  Higher real wealth stimulates
consumer spending  increases the quantity of goods and services
demanded.

The interest-rate effect: A lower price level reduces the amount of money
people want to hold  people try to lend out their excess money
holdings  the interest rate falls  lower interest rate stimulates
investment spending  increases the quantity of goods and services
demanded.

The exchange-rate effect: A lower price level reduces the interest rate 
investors move some of their funds overseas in search of higher returns
 movement of funds  causes the real value of the domestic currency
to fall in the market for foreign-currency exchange  Domestic goods
become less expensive relative to foreign goods  change in the real
exchange rate stimulates spending on net exports  increases the
quantity of goods and services demanded.
75
AD curve
Monetary Policy and AD curve
A monetary expansion: For any given price level, an increase in the money
supply raises real money balances, shifts the LM curve downward, and raises
income. Hence, an increase in the money supply shifts the aggregate demand
curve to the right. 76
AD curve
Fiscal Policy and AD curve
A fiscal expansion: an increase in government purchases or a decrease

in taxes. The fiscal expansion shifts the IS curve to the right and, for
any given price level, raises income  a fiscal expansion shifts the
aggregate demand curve to the right. 77
AD curve
Distinguish movement along AD curve

and shift in AD curve
 Change in income in the IS–LM model resulting from a
change in the price level represents a movement along the
aggregate demand curve.
 A change in income in the IS–LM model for a given price
level represents a shift in the aggregate demand curve.
78
IS-LM model in the Short-run and in the Long-run
The Short-Run and Long-Run Equilibria: compare the short-run and long-
run equilibria using either the IS–LM diagram
In the short run, the price level is stuck at P1. The short-run equilibrium of
the economy is therefore point K.
In the long run, the price level adjusts so that the economy is at the natural
level of output. The long-run equilibrium is therefore point C. 79
Short-run and Long-run
The economy as being described by three equations:

Y = C(Y – T) + I(r) + G IS - Goods Market Three endogenous
M/P = L(r,Y) LM – Monetary Market variables: Y, P, and r
P = P1 P – fixed prices, Keynesian equation
Y: natural output, Classical approach
 Keynesian approach’s assumption implies that the remaining two
variables r and Y must adjust to satisfy the remaining two equations IS
and LM.
 The classical approach’s assumption indicates that output reaches its
natural level:
 Thus, the classical approach fixes output and allows the price level to
adjust to satisfy the goods and money market equilibrium conditions,
whereas the Keynesian approach fixes the price level and lets output
move to satisfy the equilibrium conditions.
 Which assumption is most appropriate? The answer depends on the
time horizon. The classical assumption best describes the long run.
80
Short run
Shifts in Aggregate Demand

For a given price level, national income fluctuates because of shifts in the
aggregate demand curve. The IS–LM model takes the price level as given and
shows what causes income to change. The model therefore shows what causes
81
aggregate demand to shift.
Money market and Aggregate demand
Money Market & AD
 Monetary policy
o Money supply
o Interest rate target 82
Money market and AD curve
Money market & AD
 Monetary policy  change in Money Supply

 Money supply
 Interest rate target
83
Monetary policies & AD

Monetary policy can be described either in terms of the
money supply or in terms of the interest rate.

Changes in monetary policy aimed at expanding aggregate
demand can be described either as increasing the money
supply or as lowering the interest rate. Changes in
monetary policy aimed at contracting aggregate demand
can be described either as decreasing the money supply or
as raising the interest rate.
84
Multiplier effect and AD
Fiscal Policy & AD


Fiscal policy: the setting of the level of government spending
and taxation by government policymakers

Multiplier effect: the additional shifts in aggregate demand
that result when expansionary fiscal policy increases income
and thereby increases consumer spending

Multiplier m = 1 / (1 – MPC)

Marginal propensity to consume (MPC) —the fraction of
extra income that a household consumes rather than saves ( 0
< MPC ≤ 1)
85
The Multiplier effect
86
Multiplier
 Simple economy: m = 1 / (1 – MPC)
 Closed economy with government:
m = 1 / [1 – MPC (1 – t)]
t: tax rate (0 ≤ t < 1)
 Open economy
m = 1 / [1 – MPC (1 – t) + MPM]
MPM: Marginal propensity to import — the fraction of extra
income that a household consumes on imported goods rather
than saves.
87
Multiplier effect
88
OTHER APPLICATIONS OF THE MULTIPLIER EFFECT
Expansionary Fiscal policy

- Change in government spending
- Change in government tax
 Multiplier effect: increase in government spending 

aggregate demand increases  income increases
 Crowding-out effect: increase in government spending 
aggregate demand increases  income increases 
demand for money raises  raises the interest rate 
reduces investment spending
89
Change in government spending
Multiplier effect: increase in P SAS

government spending 
aggregate demand increases
P’ E’
(expansionary fiscal policy)
 income increases. E
P
 demand for money raises △Y = m x △G
…… monetary market AD’
AD
Y
Y Y’
90
Increase in government spending
Crowding-out effect: increase in government spending  aggregate demand

increases (expansionary fiscal policy)  income increases  demand for
money raises  raises the interest rate  reduces investment spending
91
Crowding-out effect

When the government increases (or decrease) its purchases,
the aggregate demand for goods and services could rise (or
reduces) by more or less depending on the sizes of the
multiplier and crowding-out effects.

The multiplier effect by itself makes the shift in aggregate
demand greater than government spending.

The crowding-out effect pushes the aggregate-demand curve
in the opposite direction and, if large enough, could result in
an aggregate-demand shift of less than government spending.
92
Crowding - out effect: increase P SAS

in government spending  Multiplier effect
aggregate demand increases
(expansionary fiscal policy)  P’ E’
income increases  demand for E’’
Crowding-
money raises raises in interest E out effect
P
rate  investment reduces 
aggregate demand reduces  AD’
AD shifts to the left AD’’
AD
Y
Y Y’
93
Change in government tax
Tax cut  increases P SAS

consumer spending
 shifts the aggregate
demand curve to the right. P’ E’
A tax increase depresses
P E
consumer spending 
AD’
shifts the aggregate -
demand curve to the left. AD
ΔY
AD’’
Y
Y Y’
94
CHANGES IN TAXES
 Multiplier and crowding-out effects.
 Multiplier effect: the government cuts taxes  stimulates
consumer spending  earnings and profits rise  stimulates
consumer spending.
 Crowding-out effect: At the same time, higher income 
leads to higher money demand  tends to raise interest
rates higher interest rates make borrowing more costly 
reduces investment spending.
 Shift in aggregate demand could be larger or smaller
 The size of the multiplier and crowding-out effects.
 Households’ perceptions about whether the tax change is permanent or
temporary.
95
Crowding-out effect: tax cut P SAS

 aggregate demand Multiplier effect
increases (expansionary fiscal

policy)  income increases P’ E’
E’’
 demand for money raises E Crowding-
out effect
raises in interest rate  P
investment reduces  AD’
aggregate demand reduces  AD’’
AD shifts to the left AD
Y
Y Y’
96
Stabilization policies
 The use of policy instruments to stabilize aggregate demand and
production and employment  Economic stabilization
 Policy instruments: Fiscal Policy & Monetary Policy
 Fiscal policy set by the president and Congress.
 Fed’s Open Market Committee (Federal Reserve)
 The government can adjust its monetary and fiscal policy in
response to these waves of optimism and pessimism  stabilize
the economy
 Keynes’s The General Theory of Employment, Interest, and Money
 when people are excessively pessimistic, the Fed can expand the money
supply to lower interest rates and expand aggregate demand.
 When they are excessively optimistic, it can contract the money supply to
raise interest rates and dampen aggregate demand.
97
Stabilization policies
 The government raises taxes  aggregate demand will fall
 depressing production and employment in the short run.
 The Federal Reserve can expand aggregate demand by
increasing the money supply (to prevent this adverse effect
of the fiscal policy).
 A monetary expansion would reduce interest rates  stimulate
investment spending expand aggregate demand.
 The combined changes in monetary and fiscal policy could
leave the aggregate demand for goods and services unaffected.
98
Criticism of Stabilization Policy

 Policy instruments should be set to achieve long-run goals,
such as rapid economic growth and low inflation
 The economy should be left to deal with short-run fluctuations
on its own
 the government should avoid active use of monetary and fiscal
policy to try to stabilize the economy.
 Monetary and fiscal policy can stabilize the economy in theory,
they doubt whether it can do so in practice.
 Long lag
 Fiscal policy
 Monetary policy
 Economic forecasting is imprecise
99
AUTOMATIC STABILIZERS
 Automatic stabilizers: changes in fiscal policy that
stimulate aggregate demand when the economy goes into a
recession without policymakers having to take any deliberate
action
 Tax system
 Government spending
 The automatic stabilizers are sufficiently strong enough or not
to prevent recessions completely?
100
AUTOMATIC STABILIZERS

Tax system

Recession  the amount of taxes collected by the government falls automatically.

Automatic tax cut stimulates aggregate demand  reduces the magnitude of
economic fluctuations.

The personal income tax depends on households’ incomes, the payroll tax depends
on workers’ earnings, the corporate income tax depends on firms’ profits.

Government spending

Recession  workers are laid off  more people apply for unemployment
insurance benefits, welfare benefits, and other forms of income support.

Automatic increase in government spending stimulates aggregate demand at exactly
the time when aggregate demand is insufficient to maintain full employment.

the unemployment insurance system in the 1930s in USA as an automatic stabilizer.
101
Automatic Stabilizer versus Strict Balanced

budget rule ran by government

A strict balanced-budget rule would eliminate the
automatic stabilizers inherent in current system of taxes and
government spending

When the economy goes into a recession taxes fall,
government spending rise  the government’s budget moves
toward deficit.

If the government faced a strict balanced-budget rule 
government would be forced to look for ways to raise taxes or
cut spending in a recession.
102
Conclusions

Long-run effect of monetary and fiscal policy (classical models of the
economy)

How fiscal policy influences saving, investment, and long-run growth

How monetary policy influences the price level and the inflation rate

Short-run effects of monetary and fiscal policy.

change the aggregate demand for goods and services and alter the economy’s
production and employment in the short run.

In all parts of government, policymakers must keep in mind both long-run
and short-run goals

Congress needs to consider both the long-run effects on saving and growth and the
short-run effects on aggregate demand and employment when it reduces government
spending to balance the budget,.

When the Fed reduces the growth rate of the money supply, it must take into account
the long-run effect on inflation as well as the short-run effect on production.
103
104
105
106
107
108
109
110
111
112
113
114
Fiscal and Monetary Policy Tools
Fiscal policy tools Monetary policy tools
- Open market operations:

- Increasing government bond purchases
Expansionary
spending - Decreasing the discount rate
tools
- Cutting taxes - Decreasing reserve
requirement
- Open market operations:
- Decreasing government bond sales
Contractionar
spending - Increasing the discount rate
y tools
- Raising taxes - Increasing reserve
requirement
115
116
117
Easy Money Tight Money
Buying securities Selling securities
Lowering the reserve Increasing the reserve

ratio ratio
Lowering the discount Rising the discount rate

rate
118
119
120
121
122
123
124
125
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AGGREGATE DEMAND &

Lecture: Trinh Thu Thuy

 Growth of productivity & real GDP.

Short run economic fluctuation

Model of Aggregate Demand &

3 The Influence of Monetary & Fiscal

Short run economic fluctuation

Short run economic fluctuation

Model of Aggregate Demand &

Model of aggregate demand & aggregate supply

 Aggregate demand curve

Aggregate demand curve & Aggregate supply curve

Aggregate demand curve

Aggregate supply curve

Price level – CPI real GDP— total quantity of goods and

 How does the economy’s behavior in the short run differ

THE AGGREGATE-DEMAND CURVE

AD curve – downward sloping

 Explain the three reasons the aggregate-demand curve

THE AGGREGATE-SUPPLY CURVE

The Long-Run Aggregate - Supply Curve: The quantity of output supplied

SHIFT IN THE LAS CURVE

 Changes in natural resources

Long-Run Growth and Inflation in the Model of

The reasons SAS upward

(i) The Stick-Wage Theory

(ii) The Sticky-Price Theory

(iii) The Misperceptions Theory about relative price

a is a number that determines how much output responds to

SHORT-RUN AGGREGATE-SUPPLY CURVE MIGHT

Long run LAS

o Each of the three theories of short-run aggregate supply emphasizes a

 WHY THE AGGREGATE-SUPPLY CURVE SLOPES

TWO CAUSES OF ECONOMIC FLUCTUATIONS

Four Steps for Analyzing Macroeconomic Fluctuations

The Long Run Equilibrium

THE EFFECTS OF A SHIFT IN AGGREGATE SUPPLY

Stagflation a period of falling output and rising prices 41

Short run economic fluctuation

Model of Aggregate Demand &

3 The Influence of Monetary & Fiscal

Aggregate demand: IS – LM model

The equilibrium of this economy

In summary, the Keynesian cross

If Y1, then planned expenditure PE1 falls short of

Government purchases multiplier:

Fiscal Policy and the Multiplier: Taxes

 The IS curve shows the combinations of the interest rate

Theory of liquidity preference

A Reduction in the Money

Income, money demand and LM curve

Income, money demand and LM curve

Deriving the LM Curve Money market in equilibrium when:

Equilibrium in the IS–LM Model

The IS–LM model. The two equations of this model:

Fiscal Policy Shift the IS Curve and Changes the

The Theory of Short-Run Fluctuations

IS – LM Model and AD Curve

The Influence of Monetary and Fiscal Policy on