KRUGMAN_WELLS_MACRO_CHAPTER14

As you can see the quantity of aggregate output

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Unformatted text preview: lier and hold the aggregate price level constant.) Figure 14-10 shows the aggregate demand curve shifted to the right by a fall in the interest rate. As you can see, the quantity of aggregate output demanded at any given Figure 14-10 Monetary Policy and the Multiplier An expansionary monetary policy drives down the interest rate, leading to an initial rise in investment spending, ∆I. This raises disposable income, which causes a rise in consumer spending, which further raises disposable income, and so on. In the end, the AD curve shifts rightward by a multiple of the initial rise in I. Aggregate price level A fall in the interest rate shifts the AD curve to the right. ∆ I × 1/(1 – MPC ) P* AD1 AD2 Real GDP Rise in investment spending, ∆ I Induced rise in consumer spending, ∆C UNCORRECTED Preliminary Edition CHAPTER 14 aggregate price level increases. To calculate how much the quantity of aggregate output demanded increases, we need to know how much a fall in the interest rate increases real GDP at a given aggregate price level, such as P*. To keep things simple, we’ll focus exclusively on changes in investment spending caused by changes in the interest rate, ignoring the direct effects on consumer spending. Although they are present in reality, they are also likely to be much smaller than the effects on investment spending. Assume that the initial aggregate demand curve is AD1, and that the decline in the interest rate increases investment spending at the aggregate price level P* by an amount ∆I. This is an example of an autonomous rise in aggregate spending, a phenomenon we studied in Chapter 10. From this point on, the analysis is exactly the same as that of any autonomous change in spending—such as an increase in consumer spending, C—that occurs because of a rise in expected future income. The initial increase in real GDP translates into an increase in disposable income. This causes a rise in consumer spending, C, and a second-round rise in real GDP. This secondround increase in real GDP leads to yet another rise in consumer spending, and so on. At each round, however, the increase in real GDP is smaller than in the previous round, because some of the increase in disposable income “leaks out” into savings due to the fact that the marginal propensity to save, MPS, is positive. In the end, the AD curve shifts to a new position such as AD2. So a fall in the interest rate, r, leads to a rise in investment spending, ∆I. This rise in investment spending leads, in turn, to a rightward shift of the AD curve that reflects both the increase in investment spending, ∆I, and an induced rise in consumer spending, ∆C. As we saw in Chapter 12, the total rise in real GDP, assuming a fixed aggregate price level, is a multiple of the initial rise in investment spending: (14-6) ∆Y = ∆I × 1 1 − MPC where MPC is the marginal propensity to consume—the increase in consumer spending if disposable income rises by $1. Two Models of Interest Rates, Revisited Earlier in this chapter we develope...
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