1. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-1 Chapter 8 Money, Interest and Income

2. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-2 Objectives Introduce a model which links the goods market and the asset market Understand how interest rates and income are linked in the goods market Understand how interest rates and income are linked in the asset market Use the IS – LM to analyse the impact of changes in monetary and fiscal policy in the short run Derive the aggregate demand curve

3. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-3 Chapter Organisation 8.1The Goods Market and the IS Curve 8.2Asset Markets and the LM Curve 8.3Equilibrium in the Goods and Money Markets 8.4Deriving the AD Schedule

4. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-4 8.1 The Goods Market and the IS Curve

5. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-5 8.1 The Goods Market and the IS Curve Figure 8.3 illustrates how the goods market and asset markets are linked. Spending, income and interest rates are determined jointly by equilibrium in the goods and asset markets.

6. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-6 The Goods Market and the IS Curve The IS−LM model can be used to determine the impact of changes in policy. Fiscal policy impact on the goods market and through income to the asset market. Monetary policy impacts on the money market and through interest rates to the goods market.

7. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-7 The Goods Market and the IS Curve The IS curve represents the goods market equilibrium schedule. The IS curve shows the combination of interest rates and output such that planned spending equals income (goods market equilibrium). The IS curve is derived using two steps: –Introduction of interest rates and their effect on investment –Implementation of the investment demand function in the aggregate demand identity.

8. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-8 Investment and the Interest Rate Including interest rates in the model implies that investment spending is endogenous. The investment spending function (Equation (8.1)) is: –Where i is the rate of interest and b measures the responsiveness of investment spending to the interest rate –Autonomous investment is still a component of autonomous spending

9. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-9 Investment and the Interest Rate Equation 8.1 states that the lower the interest rate, the higher is planned investment. If b is large, then a relatively small increase in the interest rate generates a large drop in investment spending.

10. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-10 The Interest Rate and Aggregate Demand With investment dependent upon interest rates the new AD function (Equations (8.2) & (8.3)) is: –A higher interest rate reduces investment spending which reduces AD for a given level of income. –Autonomous investment is still a component of autonomous spending.

11. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-11 The IS Curve

12. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-12 The IS Curve (cont.)

13. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-13 The IS Curve In Figure 8.5, for a given interest rate, bi 1 is a constant The intercept of the AD curve in Figure 8.5(a) is now A – bi 1. The equilibrium level of income is Y 1 and E 1. Because equilibrium income was derived for the given interest rate we plot the interest rate and income in Figure 8.5(b). This is one combination of interest rates i 1 and income Y 1 that clears the goods market.

14. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-14 The IS Curve If interest rates decrease to i 2 investment spending increases. The AD curve shifts up with a new intercept. Equilibrium is now at E 2 with income at Y 2 This is represented by point E 2 in Figure 8.5(b) with lower interest rate i 2 and higher income Y 2 All possible combinations of interest rates and income which clear the goods market make up the IS curve.

15. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-15 The IS Curve We can derive the IS curve by using the goods market equilibrium condition AD = Y. This can be simplified into Equation (8.5) which gives the IS curve. (8.4)

16. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-16 The Slope of the IS Curve The IS curve is negatively sloped because: –Higher levels of interest rates reduce investment spending which reduces AD and equilibrium Y. The steepness of the curve depends on the sensitivity of investment spending to changes in the interest rate (b): –If b is large then a given change in interest rates produces a large shift in AD. –This produces a correspondingly large change in income, so that the IS curve is flat.

17. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-17 The Slope of the IS Curve The steepness of the curve also depends on the size of the multiplier  G : –If  G is large then the AD curve is steeper –An increase in the interest rate will therefore coincide with a higher equilibrium income. Figure 8.6 (a) and (b) shows the larger the multiplier the flatter the IS curve.

18. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-18 The Slope of the IS Curve

19. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-19 The Slope of the IS Curve (cont.)

20. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-20 Positions Off the IS Curve The IS curve represents income and interest rate combinations for which the goods market is in equilibrium. Combinations of income and interest rates not on the IS curve are points of goods market disequilibrium. Forces for economic adjustment will move the economy towards equilibrium.

21. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-21 Positions Off the IS Curve

22. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-22 Positions Off the IS Curve (cont.)

23. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-23 Positions Off the IS Curve Refer to Figure 8.8. At disequilibrium point E 3 there is an excess demand for goods (EDG): –At E 3 the interest rate is below the equilibrium rate at E 1. –At E 3 output is below the equilibrium level at E 2. –Economic adjustment will occur through the inventory system to increase the output of goods.

24. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-24 Positions Off the IS Curve At disequilibrium point E 4 there is an excess supply of goods (ESG): –At E 4 the interest rate is above the equilibrium rate at E 2. –At E 4 output is above the equilibrium level at E 1. –Economic adjustment will occur through the inventory system to reduce the output of goods.

25. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-25 Chapter Organisation 8.1The Goods Market and the IS Curve 8.2Asset Markets and the LM Curve 8.3Equilibrium in the Goods and Money Markets 8.4Deriving the AD Schedule

26. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-26 8.2 Asset Markets and the LM Curve The asset markets: markets where money, bonds, shares, debentures, and other forms of wealth are traded. Assume that financial assets are categorised as either: –Money –Interest-bearing assets.

27. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-27 The Wealth Constraint Portfolio decisions are decisions about which types of financial assets to hold e.g. bonds or money. The real demand for money is called the demand for real-money balances. The wealth budget constraint –The demand for real-money balances L plus the demand for real bond holdings DB must equal real financial wealth WN/P in constraint (Equation (8.6)):

28. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-28 The Wealth Constraint The total amount of financial wealth in the economy consists of real money balances and real bonds. Substituting Equation (8.6) into Equation (8.7) gives Equation (8.8). (8.7)

29. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-29 The Wealth Constraint Equation (8.8) indicates that: –If the money market is in equilibrium, the bond market must also be in equilibrium. –If L > M/P then DB SB

30. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-30 The LM Curve The LM curve represents points of money market equilibrium. The LM curve shows combinations of: –Interest rates and levels of output such that money demand equals money supply. Let's now consider the demand for real-money balances and the supply of money.

31. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-31 The Demand for Money The demand for money is –The demand for real balances because people hold money for what it can buy. The higher the price level –The more nominal balances a person has to hold in order to purchase a given quantity of goods.

32. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-32 The Demand for Money The demand for real balances (Equation (8.9)) –L = kY – hi –Depends on the level of real income Y and the interest rate i. The higher the income, the greater the demand for real balances. The higher the interest rate –The lower the demand for real balances because the cost of holding money is higher.

33. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-33 The Demand for Money k represents the sensitivity of the demand for real balances to the level of income. Higher k means people wish to hold a greater proportion of income in money. h represents the sensitivity of the demand for real balances to interest rates. Higher h means people economise on holding money because the opportunity cost is higher.

34. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-34 The Supply of Money The RBA controls the nominal money supply (M) through OMO. _ _ The real money supply is M/P. The LM curve shows all combinations of interest rates and income such that –The demand for real balances is equal to the real money supply (i.e. money market equilibrium).

35. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-35 Deriving the LM Curve

36. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-36 Deriving the LM Curve (cont.)

37. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-37 Deriving the LM Curve Figure 8.10b shows the combinations of interest rates and income such that the demand for real balances equals the supply. If output is Y 1 and the interest rate i 1 the demand of real balances equals money supply representing money market equilibrium. The interest rate and income combination is point E 1 on the LM curve in Figure 8.10a.

38. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-38 Deriving the LM Curve If Y increases to Y 2 in Figure 8.10(b) then: –The higher Y increases the demand for real-money balances at each level of interest rates. –This increase is shown as the rightward shift in the demand for real balances to L 2 –The interest rate must increase to i 1 to maintain money market equilibrium. The new equilibrium point is E 2 on the LM curve in Figure 8.10(a).

39. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-39 Deriving the LM Curve For money market equilibrium, demand for real balances must equal supply. This is the LM curve in Figure 8.10a. (8.10) (8.10a)

40. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-40 Deriving the LM Curve Money market equilibrium implies that an increase in the interest rate must be accompanied by an increase in output. The greater the responsiveness of L to Y (the larger k is), the steeper the LM curve. The lower the responsiveness of L to i (the smaller h is), the steeper the LM curve.

41. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-41 Positions of the LM Curve

42. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-42 Positions of the LM Curve Combinations of income and interest rates not on the LM curve are points of money market disequilibrium At disequilibrium point E 3 there is an excess supply of real-money balances (ESM) –At E 3 the interest rate is above the equilibrium rate at E 1 –At E 3 output is below the equilibrium level at E 2 –At E 3 there is pressure on interest rates to fall

43. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-43 Positions of the LM Curve At disequilibrium point E 4 there is an excess demand of real-money balances (EDM) –At E 4 the interest rate is below the equilibrium rate at E 2 –At E 4 output is above the equilibrium level at E 1 –At E 4 there is pressure on interest rates to rise.

44. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-44 Chapter Organisation 8.1The Goods Market and the IS Curve 8.2Asset Markets and the LM Curve 8.3Equilibrium in the Goods and Money Markets 8.4Deriving the AD Schedule

45. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-45 8.3 Equilibrium in the Goods and Money Markets For simultaneous equilibrium: –Interest rates and Y must be such that both the goods and money markets are in equilibrium. This is the unique point E where the IS and LM curves intersect.

46. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-46 Equilibrium in the Goods and Money Markets

47. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-47 Changes in the Equilibrium Levels of Income and Interest Rates Equilibrium levels of income and interest rates change when changes in the goods or money market cause the IS or the LM curve to shift. Assume an increase in autonomous investment (Figure 8.14). The IS curve shifts rightwards by this autonomous increase times the multiplier  G. There will be higher equilibrium income Y' and interest rates i'. At E' both the goods and money markets will be in equilibrium.

48. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-48 Changes in the Equilibrium Levels of Income and Interest Rates

49. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-49 Changes in the Equilibrium Levels of Income and Interest Rates Why has Y increased by a smaller amount than the multiple increase in autonomous spending? –Increased autonomous spending increases Y. –However, this increases the demand for money. –If M/P is fixed, the interest rate i must rise to equilibrate the money market. –Increased interest rates rise, induced investment decreases which dampens the expansionary effect.

50. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-50 Chapter Organisation 8.1The Goods Market and the IS Curve 8.2Asset Markets and the LM Curve 8.3Equilibrium in the Goods and Money Markets 8.4Deriving the AD Schedule

51. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-51 8.4 Deriving the AD Schedule

52. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-52 Deriving the AD Schedule (cont.)

53. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 8-53 Deriving the AD Schedule The AD schedule maps out the possible IS–LM equilibrium conditions allowing the price level P to vary. Holding M constant, a higher P means a lower M/P. The interest rate i must rise to restore money market equilibrium (LM shifts up). Increased interest rates reduce investment demand and therefore AD.