1. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 0

2. C H A P T E R 11 Money, Interest, and Income Learning objectives äUnderstand that the IS-LM model is the core of short run macroeconomics. äUnderstand that the IS curve describes the combination of income and interest rates at which the goods market is in equilibrium. äUnderstand that the LM curve describes the combination of income and interest rates at which the money market is in equilibrium. äUnderstand that, together, the IS and LM curves constitute the model of aggregate demand. äUnderstand that, in the short run, increases in government spending raise output and interest rates, while increases in the real money supply raise output and lower interest rates. PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa Copyright 2005 © McGraw-Hill Ryerson Ltd.

3. Slide 2 IS-LM Model oIS-LM model: Interaction of IS and LM curves determines the real interest rate and the level of income for a given price level, for which both goods and money markets are in equilibrium. Chapter 11: Money, Interest, and Income

4. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 3 IS-LM Model Chapter 11: Money, Interest, and Income Figure 11-1: The Short Run Relationship of Money, The Interest Rate, and Output, 1969-2002

5. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 4 The Goods Market and the IS Curve oIS curve (goods market equilibrium): Shows combinations of the interest rate and income for which the goods market is in equilibrium. oInvestment and the interest rate: Chapter 11: Money, Interest, and Income (1)(1)

6. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 5 The Goods Market and the IS Curve Chapter 11: Money, Interest, and Income Interest Rates i Planned Investment Spending I Investment spending is negatively related to the rate of interest. Figure 11-2: The Investment Demand Curve

7. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 6 The Goods Market and the IS Curve The AD equation from Chapter 10 Chapter 11: Money, Interest, and Income The AD equation in Chapter 11 (2) (3) (4) (5)

8. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 7 The Goods Market and the IS Curve Chapter 11: Money, Interest, and Income Aggregate demand Income, Output Figure 11-3 a): Derivation of the IS curve AD At E 1, income is at Y 1. A decrease in the interest rate raises AD. AD = Y Y1Y1Y1Y1 E1E1E1E1 Y2Y2Y2Y2 E2E2E2E2

9. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 8 The Goods Market and the IS Curve Chapter 11: Money, Interest, and Income Figure 11-3 b): Derivation of the IS curve Interest rate Income, Output i At E 1, income is at Y 1. A decrease in the interest rate raises AD. Y1Y1Y1Y1 Y2Y2Y2Y2 E1E1E1E1 i1i1i1i1 E2E2E2E2 i2i2i2i2 IS

10. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 9 Savings, Investment, and Equilibrium: Why is Chap 3 different from Chap 11? BOXBOX 11-1 Savings now depends on income

11. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 10 The Goods Market and the IS Curve oThe Slope of the IS Curve: The IS curve is negatively sloped because higher interest rates decrease investment spending. The steepness of the curve depends on: 1)On b: If b is large, a given change in the interest rate produces a large change in aggregate demand. 2)On the multiplier,  G (eq. 5). For a given drop in interest rate, the larger the multiplier, the steeper the AD curve, the flatter the IS curve and the greater the rise in income. (see Figures 11-4 a) and b)). Chapter 11: Money, Interest, and Income

12. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 11 The Goods Market and the IS Curve Chapter 11: Money, Interest, and Income Aggregate demand Income, Output Figure 11-4 a): Effect of the Multiplier on the Slope of the IS Curve AD AD = Y Y1Y1Y1Y1 Y2Y2Y2Y2 Y’ 2 -b  i Y’ 1

13. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 12 The Goods Market and the IS Curve Chapter 11: Money, Interest, and Income Figure 11-4 b): Effect of the Multiplier on the Slope of the IS Curve Interest rate Income, Output i i1i1i1i1 i2i2i2i2 IS IS’ Y’ 1 Y’ 2 Y2Y2Y2Y2 Y1Y1Y1Y1

14. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 13 The Goods Market and the IS Curve oPosition of the IS curve: The level of autonomous spending from equation 2 is: Chapter 11: Money, Interest, and Income

15. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 14 The Goods Market and the IS Curve Chapter 11: Money, Interest, and Income Aggregate demand Income, Output Figure 11-5 a): A Change in Autonomous Spending AD An increase in autonomous spending… AD = Y Y1Y1Y1Y1 E1E1E1E1 Y2Y2Y2Y2 E2E2E2E2

16. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 15 The Goods Market and the IS Curve Chapter 11: Money, Interest, and Income Figure 11-5 b): A Change in Autonomous Spending Interest rate Income, Output i i1i1i1i1 IS IS’ Y2Y2Y2Y2 Y1Y1Y1Y1 E1E1E1E1 E2E2E2E2

17. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 16 Summary of the IS curve IS curveThe IS curve is the schedule of combinations of the interest rate level and level of income such that the goods market is in equilibrium. IS curveThe IS curve is negatively sloped because an increase in the interest rate reduces planned investment spending and therefore reduces aggregate demand, thus reducing the aggregate level of income. IS curveThe smaller the multiplier and the less sensitive investment spending is to changes in the interest rate, the steeper the IS curve. IS curveThe IS curve is shifted by changes in autonomous spending. Chapter 11: Money, Interest, and Income

18. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 17 The Money Market and the LM Curve oDemand for Money (real balances): Quantity of real money balances people wish to hold. The higher the price level, the more nominal balances a person must hold to be able to purchase a given quantity of goods and services. oThe demand for real balances depends on two things: 1)The level of real income. 2)The interest rate. Chapter 11: Money, Interest, and Income(6)

19. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 18 The Money Market and the LM Curve Chapter 11: Money, Interest, and Income Figure 11-6: Demand for Real Balances as a Function of i and Y Interest rate Demand for money i The higher the interest rate, the lower the quantity of real balances demanded, given the level of income. An increase in income raises the demand for money.

20. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 19 Therefore, for a given real money supply, a higher level of income is consistent with a higher interest rate for money market equilibrium, and the LM curve slopes upward. The Money Market and the LM Curve Figure 11-7: Derivation of the LM curve Interest rate Real Balances i Income, Output iLM E1E1E1E1 i1i1i1i1 If income increases to Y 2, with the real money supply remaining constant, the interest rate must increase to i 2, to maintain money market equilibrium at E 2. Y1Y1Y1Y1 Y2Y2Y2Y2 E2E2E2E2 i2i2i2i2 E2E2E2E2 E1E1E1E1 At the initial equilibrium, E 1, the real money demand equals the real money supply for a given Y 1.

21. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 20 The Money Market and the LM Curve oThe LM curve can be obtained directly by combining the demand curve for real balances, equation (6), and the fixed supply of real balances. For the money market to be in equilibrium, demand has to equal supply, or Chapter 11: Money, Interest, and Income (7)(7) (7a)(7a) LM curve

22. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 21 The Money Market and the LM Curve oThe Slope of the LM Curve: The slope of the LM curve that we derived in Figure 11- 7 depends on how much the money demand curve shifts upward (L 1 to L 2 ) when income changes from Y 1 to Y 2. From equation (7a), for larger k, the income elasticity of money demand, and for smaller h, the interest elasticity of money demand, the LM curve is steeper. oShifts in the LM curve: A change in the real money supply will shift the LM curve. Chapter 11: Money, Interest, and Income

23. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 22 The Money Market and the LM Curve Figure 11-8: Shifting the LM curve Interest rate Real Balances i An increase in the money supply shifts the LM curve outward.. Income, Output i E1E1E1E1 LM’ E2E2E2E2 i1i1i1i1 Y2Y2Y2Y2 LM E2E2E2E2 E1E1E1E1 i2i2i2i2

24. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 23 Summary of the LM curve LM curveThe LM curve shows the combinations of interest rates and levels of income such that the money market is in equilibrium. LM curveThe LM curve is positively sloped. Given the fixed money supply, an increase in the level of income, which increases the quantity of money demanded, has to be accompanied by an increase in the interest rate. This reduces the quantity of money demanded and therefore maintains money market equilibrium. LM curve LM curveThe LM curve is shifted by changes in the money supply. An increase in the money supply shifts the LM curve to the right. Chapter 11: Money, Interest, and Income

25. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 24 Money Demand and the Quantity Theory BOXBOX 11-3

26. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 25 Equilibrium in the Goods and Money Markets Equilibrium in the goods and money markets… How these markets are brought into simultaneous equilibrium. For simultaneous equilibrium, interest rates and income levels have to be such that both the goods market and the money market are in equilibrium… … See point E… Chapter 11: Money, Interest, and Income

27. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 26 At point E, interest rates and income levels are such that the public holds the existing money stock and planned spending equals output. Equilibrium in the Goods and Money Markets Chapter 11: Money, Interest, and Income Figure 11-9: Goods and Money Market Equilibrium Interest rate Income, Output i Y0Y0Y0Y0 ISLM E i0i0i0i0

28. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 27 Equilibrium in the Goods and Money Markets Figure 11-10: Comparing the Effects of Monetary and Fiscal Policy Interest rate Income, Output i Y1Y1Y1Y1 ISLM i1i1i1i1 Y1Y1Y1Y1 IS LM i1i1i1i1 IS’ Y2Y2Y2Y2 i2i2i2i2 Y2Y2Y2Y2 LM’ i2i2i2i2

29. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 28 Deriving the Aggregate Demand Curve oAggregate Demand Curve: Maps out the IS-LM equilibrium holding autonomous spending and the nominal money supply constant and allowing prices to vary. Chapter 11: Money, Interest, and Income

30. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 29 Deriving the Aggregate Demand Curve Figure 11-11: Derivation of the Aggregate Demand Schedule Income, Output Y1Y1Y1Y1 IS LM i1i1i1i1 Y2Y2Y2Y2 LM’ i2i2i2i2 For a given nominal money stock, a price level decrease increases the real money stock. This shifts the the LM curve outward, and the interest rate goes down and income increases.

31. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 30 AD Deriving the Aggregate Demand Curve Chapter 11: Money, Interest, and Income Figure 11-11: Derivation of the Aggregate Demand Schedule (cont’d) Price level Income, Output i Y2Y2Y2Y2 Y1Y1Y1Y1 E2E2E2E2 P2P2P2P2 E1E1E1E1 P1P1P1P1 Therefore, along the AD curve, a price level decrease (holding the nominal money stock constant) is consistent with an income increase, and the AD curve slopes downward.

32. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 31 Action Policy in Action Monetary and Fiscal Policy Stance in the late 1970s.

33. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 32 Chapter Summary The IS-LM model presented in this chapter is the basic model of aggregate demand that incorporates the money market as well as the goods market. The IS curve shows combinations of interest rates and levels of income such that the goods market is in equilibrium. The demand for money is the demand for real balances. The interest rate and the level of output are jointly determined by simultaneous equilibrium of the goods and money markets. Chapter 11: Money, Interest, and Income

34. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 33 Chapter Summary (cont’d) Monetary policy affects the economy first by affecting the interest rate and then by affecting aggregate demand. The IS and LM curves together determine the aggregate demand curve. Chapter 11: Money, Interest, and Income

35. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 34 The End Chapter 11: Money, Interest, and Income