© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 12 Prepared by: Fernando Quijano and Yvonn Quijano Money, the Interest Rate, and Output: Analysis and Policy

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Links Between the Goods Market and the Money Market The goods and money markets do not operate independently. There is a value of output (income) (Y) and a level of the interest rate (r) that are consistent with the existence of equilibrium in both markets.The goods and money markets do not operate independently. There is a value of output (income) (Y) and a level of the interest rate (r) that are consistent with the existence of equilibrium in both markets. This chapter examines how monetary and fiscal policies affect the level of output, interest rates, and investment spending.This chapter examines how monetary and fiscal policies affect the level of output, interest rates, and investment spending.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Link 1: Income and the Demand for Money Income, which is determined in the goods market, has considerable influence on the demand for money in the money market.Income, which is determined in the goods market, has considerable influence on the demand for money in the money market. An increase in aggregate output (income) shifts the money demand curve, which raises the equilibrium interest rate from 7 percent to 14 percent.An increase in aggregate output (income) shifts the money demand curve, which raises the equilibrium interest rate from 7 percent to 14 percent.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Link 2: Planned Investment and the Interest Rate The interest rate, which is determined in the money market, has significant effects on planned investment in the goods market.The interest rate, which is determined in the money market, has significant effects on planned investment in the goods market. When the interest rate falls, planned investment rises, and when the interest rate rises, planned investment falls (fewer projects are likely to be undertaken).When the interest rate falls, planned investment rises, and when the interest rate rises, planned investment falls (fewer projects are likely to be undertaken).

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Interest Rate and Planned Aggregate Expenditure An increase in the interest rate from 3 percent to 6 percent lowers planned aggregate expenditure and thus reduces equilibrium income from Y 0 to Y 1.An increase in the interest rate from 3 percent to 6 percent lowers planned aggregate expenditure and thus reduces equilibrium income from Y 0 to Y 1.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Money Demand, Aggregate Output (Income), and the Money Market The equilibrium interest rate is not determined exclusively in the money market. Changes in aggregate output (income), which take place in the goods market, shift the money demand curve and cause changes in the interest rate.The equilibrium interest rate is not determined exclusively in the money market. Changes in aggregate output (income), which take place in the goods market, shift the money demand curve and cause changes in the interest rate.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Expansionary Policy Effects Expansionary fiscal policy is either an increase in government spending or a reduction in net taxes aimed at increasing aggregate output (income) (Y).Expansionary fiscal policy is either an increase in government spending or a reduction in net taxes aimed at increasing aggregate output (income) (Y). Expansionary monetary policy is an increase in the money supply aimed at increasing aggregate output (income) (Y).Expansionary monetary policy is an increase in the money supply aimed at increasing aggregate output (income) (Y).

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Crowding-Out Effect The tendency for increases in government spending to cause reductions in private investment spending is called the crowding-out effect.The tendency for increases in government spending to cause reductions in private investment spending is called the crowding-out effect. Y increases less than if r did not increase

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Expansionary Monetary Policy: An Increase in the Money Supply An increase in the money supply decreases the interest rate and increases investment and income.An increase in the money supply decreases the interest rate and increases investment and income. However, the higher level of Y increases the demand for money, and this keeps the interest rate from falling as far as it otherwise would.However, the higher level of Y increases the demand for money, and this keeps the interest rate from falling as far as it otherwise would. r decreases less than if M d did not increase.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Effectiveness of Monetary Policy The effectiveness of monetary policy depends on the shape (or responsiveness) of the investment function.The effectiveness of monetary policy depends on the shape (or responsiveness) of the investment function. The steeper the investment function, the less responsive investment is to changes in interest rates. This lack of responsiveness may render monetary policy ineffective.The steeper the investment function, the less responsive investment is to changes in interest rates. This lack of responsiveness may render monetary policy ineffective.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Fed Accommodation of an Expansionary Fiscal Policy An expansionary fiscal policy (higher government spending or lower taxes) will increase aggregate output (income), shift the money demand curve to the right, and put upward pressure on the interest rate.An expansionary fiscal policy (higher government spending or lower taxes) will increase aggregate output (income), shift the money demand curve to the right, and put upward pressure on the interest rate.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Fed Accommodation of an Expansionary Fiscal Policy If the money supply were unchanged, the interest rate would rise. But if the Fed were to “accommodate” the fiscal expansion, the interest rate would not rise.If the money supply were unchanged, the interest rate would rise. But if the Fed were to “accommodate” the fiscal expansion, the interest rate would not rise.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Contractionary Policy Effects Contractionary fiscal policy refers to a decrease in government spending or an increase in net taxes aimed at decreasing aggregate output (income) (Y).Contractionary fiscal policy refers to a decrease in government spending or an increase in net taxes aimed at decreasing aggregate output (income) (Y).

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Contractionary Policy Effects The decrease in Y would be less than it would be if we did not take the money market into account.The decrease in Y would be less than it would be if we did not take the money market into account. Y decreases less than if r did not decrease.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Contractionary Monetary Policy Contractionary monetary policy refers to a decrease in the money supply aimed at decreasing aggregate output (income) (Y).Contractionary monetary policy refers to a decrease in the money supply aimed at decreasing aggregate output (income) (Y).

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Contractionary Monetary Policy The increase in the interest rate will be less than it would be if we did not take the goods market into account.The increase in the interest rate will be less than it would be if we did not take the goods market into account. Y decreases less than if r did not decrease.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Macroeconomic Policy Mix Forces push the variable in different directions. Without additional information, we cannot specify which way the variable moves. ?: Variable decreases. : Variable increases. : Key: ( M s ) Y, r ?, I ?, C Y ?, r, I, C ? Contractionary MONETARY ( M s ) Y ?, r, I, C ? Y, r ?, I ?, C Expansionary Contractionary ( G or T) Expansionary ( G or T) FISCAL The Effects of the Macroeconomic Policy Mix

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Other Determinants of Planned Investment The interest rateThe interest rate Expectations of future salesExpectations of future sales Capital utilization ratesCapital utilization rates Relative capital and labor costsRelative capital and labor costs The determinants of planned investment are:

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Appendix: The IS-LM Diagram The IS-LM diagram is a way of depicting graphically the determination of aggregate output (income) and the interest rate in the goods and money markets.The IS-LM diagram is a way of depicting graphically the determination of aggregate output (income) and the interest rate in the goods and money markets. The IS curve shows a negative relationship between the equilibrium value of Y and r.The IS curve shows a negative relationship between the equilibrium value of Y and r. Each point on the curve represents equilibrium in the goods market for a given value of the interest rate.Each point on the curve represents equilibrium in the goods market for a given value of the interest rate.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Appendix: The IS-LM Diagram The LM curve shows a positive relationship between the equilibrium value of Y and r.The LM curve shows a positive relationship between the equilibrium value of Y and r. Each point on the curve represents equilibrium in the money market for a given value of aggregate output (income).Each point on the curve represents equilibrium in the money market for a given value of aggregate output (income). The LM curve is upward-sloping because higher income results in higher demand for money and a higher interest rate.The LM curve is upward-sloping because higher income results in higher demand for money and a higher interest rate.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Appendix: The IS-LM Diagram The point at which the IS and the LM curves intersect corresponds to the point at which the goods market and the money market are in equilibrium.The point at which the IS and the LM curves intersect corresponds to the point at which the goods market and the money market are in equilibrium.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Appendix: The IS-LM Diagram An increase in government spending shifts the IS curve to the right.An increase in government spending shifts the IS curve to the right. This increases the value of both Y and r.This increases the value of both Y and r.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Appendix: The IS-LM Diagram An increase in the money supply shifts the LM curve to the right.An increase in the money supply shifts the LM curve to the right. This increases the value of Y and decreases the value of r.This increases the value of Y and decreases the value of r.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Appendix: The IS-LM Diagram It is easy to use the IS/LM diagram to see how there can be a monetary and fiscal policy mix that leads to a particular outcome.It is easy to use the IS/LM diagram to see how there can be a monetary and fiscal policy mix that leads to a particular outcome. For example, an increase in the money supply, accompanied by an increase in government spending leads to an increase in aggregate output, with no change in the interest rate.For example, an increase in the money supply, accompanied by an increase in government spending leads to an increase in aggregate output, with no change in the interest rate.