1. © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair Prepared by: Fernando & Yvonn Quijano 12 Chapter PART IV MACROECONOMIC ANALYSIS Money, the Interest Rate, and Output: Analysis and Policy

2. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 45 Chapter Outline 12 Money, the Interest Rate, and Output: Analysis and Policy PART IV MACROECONOMIC ANALYSIS The Links Between the Goods Market and the Money Market Investment, the Interest Rate, and the Goods Market Money Demand, Aggregate Output (Income), and the Money Market Combining the Goods Market and the Money Market Expansionary Policy Effects Contractionary Policy Effects The Macroeconomic Policy Mix Other Determinants of Planned Investment Looking Ahead: The Price Level Appendix: The IS-LM Diagram

3. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 3 of 45 MONEY, THE INTEREST RATE, AND OUTPUT: ANALYSIS AND POLICY goods market The market in which goods and services are exchanged and in which the equilibrium level of aggregate output is determined. money market The market in which financial instruments are exchanged and in which the equilibrium level of the interest rate is determined.

4. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 4 of 45 THE LINKS BETWEEN THE GOODS MARKET AND THE MONEY MARKET There are two key links between the goods market and the money market: ■ 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. ■ Link 2: Planned Investment Spending and the Interest Rate The interest rate, which is determined in the money market, has significant effects on planned investment in the goods market.

5. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 5 of 45 An increase in output, all else the same, leads to: a.An increase in money demand. b.An increase in money supply. c.A decrease in the interest rate. d.An increase in both the supply and the demand for money.

6. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 6 of 45 An increase in output, all else the same, leads to: a.An increase in money demand. b.An increase in money supply. c.A decrease in the interest rate. d.An increase in both the supply and the demand for money.

7. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 7 of 45 THE LINKS BETWEEN THE GOODS MARKET AND THE MONEY MARKET FIGURE 12.1 Links Between the Goods Market and the Money Market

8. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 8 of 45 THE LINKS BETWEEN THE GOODS MARKET AND THE MONEY MARKET INVESTMENT, THE INTEREST RATE, AND THE GOODS MARKET When the interest rate falls, planned investment rises. When the interest rate rises, planned investment falls. FIGURE 12.2 Planned Investment Schedule

9. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 9 of 45 Reducing the interest rate, ceteris paribus, is likely to: a.Increase the level of planned investment spending. b.Decrease the level of planned investment. c.Shift the demand for money curve to the right. d.Shift the supply of money curve to the right.

10. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 10 of 45 Reducing the interest rate, ceteris paribus, is likely to: a.Increase the level of planned investment spending. b.Decrease the level of planned investment. c.Shift the demand for money curve to the right. d.Shift the supply of money curve to the right.

11. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 11 of 45 THE LINKS BETWEEN THE GOODS MARKET AND THE MONEY MARKET FIGURE 12.3 The Effect of an Interest Rate Increase on Planned Aggregate Expenditure

12. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 12 of 45 THE LINKS BETWEEN THE GOODS MARKET AND THE MONEY MARKET The effects of a change in the interest rate include: ■High interest rate (r) discourages planned investment (I). ■Planned investment is a part of planned aggregate expenditure (AE). ■Thus, when the interest rate rises, planned aggregate expenditure (AE) at every level of income falls. ■Finally, a decrease in planned aggregate expenditure lowers equilibrium output (income) (Y) by a multiple of the initial decrease in planned investment. Using a convenient shorthand:

13. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 13 of 45 When the interest rate rises, planned investment falls, and equilibrium output (income): a.Rises by exactly the same amount as the fall in planned investment. b.Rises by even more than the fall in planned investment. c.Falls by exactly the same amount as the fall in planned investment. d.Falls by even more than the fall in planned investment.

14. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 14 of 45 When the interest rate rises, planned investment falls, and equilibrium output (income): a.Rises by exactly the same amount as the fall in planned investment. b.Rises by even more than the fall in planned investment. c.Falls by exactly the same amount as the fall in planned investment. d.Falls by even more than the fall in planned investment.

15. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 15 of 45 THE LINKS BETWEEN THE GOODS MARKET AND THE MONEY MARKET MONEY DEMAND, AGGREGATE OUTPUT (INCOME), AND THE MONEY MARKET FIGURE 12.4 Equilibrium in the Money Market

16. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 16 of 45 THE LINKS BETWEEN THE GOODS MARKET AND THE MONEY MARKET FIGURE 12.5 The Effect of an Increase in Income (Y) on the Interest Rate (r)

17. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 17 of 45 THE LINKS BETWEEN THE GOODS MARKET AND THE MONEY MARKET The equilibrium level of the interest rate is not determined exclusively in the money market. Changes in aggregate output (income) (Y), which take place in the goods market, shift the money demand curve and cause changes in the interest rate. With a given quantity of money supplied, higher levels of Y will lead to higher equilibrium levels of r. Lower levels of Y will lead to lower equilibrium levels of r, as represented in the following symbols:

18. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 18 of 45 For every possible level of the interest rate there is: a.Only one equilibrium level of Y. b.A different equilibrium level of Y. c.A possible equilibrium in the money market but never simultaneous with equilibrium in the money market. d.Always equilibrium in both the goods and money markets.

19. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 19 of 45 For every possible level of the interest rate there is: a.Only one equilibrium level of Y. b.A different equilibrium level of Y. c.A possible equilibrium in the money market but never simultaneous with equilibrium in the money market. d.Always equilibrium in both the goods and money markets.

20. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 20 of 45 COMBINING THE GOODS MARKET AND THE MONEY MARKET EXPANSIONARY POLICY EFFECTS expansionary fiscal policy An increase in government spending or a reduction in net taxes aimed at increasing aggregate output (income) (Y). expansionary monetary policy An increase in the money supply aimed at increasing aggregate output (income) (Y).

21. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 21 of 45 COMBINING THE GOODS MARKET AND THE MONEY MARKET crowding-out effect The tendency for increases in government spending to cause reductions in private investment spending. Expansionary Fiscal Policy: An Increase in Government Purchases (G) or a Decrease in Net Taxes (T)

22. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 22 of 45 COMBINING THE GOODS MARKET AND THE MONEY MARKET FIGURE 12.6 The Crowding-Out Effect

23. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 23 of 45 Which multiplier effect is smaller? a.The multiplier of an increase in government spending. b.The multiplier of a decrease in net taxes. c.Neither multiplier above is smaller. The magnitude of a change in equilibrium GDP from either the multiplier of government spending or the multiplier of net taxes is identical. d.Any multiplier of autonomous expenditures other than the multiplier of G or T.

24. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 24 of 45 Which multiplier effect is smaller? a.The multiplier of an increase in government spending. b.The multiplier of a decrease in net taxes. c.Neither multiplier above is smaller. The magnitude of a change in equilibrium GDP from either the multiplier of government spending or the multiplier of net taxes is identical. d.Any multiplier of autonomous expenditures other than the multiplier of G or T.

25. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 25 of 45 COMBINING THE GOODS MARKET AND THE MONEY MARKET interest sensitivity or insensitivity of planned investment The responsiveness of planned investment spending to changes in the interest rate. Interest sensitivity means that planned investment spending changes a great deal in response to changes in the interest rate; interest insensitivity means little or no change in planned investment as a result of changes in the interest rate. Effects of an expansionary fiscal policy:

26. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 26 of 45 COMBINING THE GOODS MARKET AND THE MONEY MARKET Effects of an expansionary monetary policy: Expansionary Monetary Policy: An Increase in the Money Supply

27. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 27 of 45 Fed accommodation of an increase in government spending causes the multiplier of government spending to be: a.Larger. b.Smaller. c.Reduced to zero. d.Infinity.

28. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 28 of 45 Fed accommodation of an increase in government spending causes the multiplier of government spending to be: a.Larger. b.Smaller. c.Reduced to zero. d.Infinity.

29. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 29 of 45 COMBINING THE GOODS MARKET AND THE MONEY MARKET Expansionary Policy in Action: The Recessions of 1974–1975, 1980–1982, 1990–1991, and 2001 FIGURE 12.7 Fed Accommodation of an Expansionary Fiscal Policy

30. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 30 of 45 COMBINING THE GOODS MARKET AND THE MONEY MARKET CONTRACTIONARY POLICY EFFECTS Contractionary Fiscal Policy: A Decrease in Government Spending (G) or an Increase in Net Taxes (T) contractionary fiscal policy A decrease in government spending or an increase in net taxes aimed at decreasing aggregate output (income) (Y). Effects of a contractionary fiscal policy:

31. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 31 of 45 A decrease in net taxes results in: a.A decrease in Y, a decrease in r, and an increase in I. b.An increase in Y, an increase in r, and a decrease in I. c.An increase in Y, a decrease in r, and an increase in I. d.A decrease in Y, an increase in r, and a decrease in I.

32. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 32 of 45 A decrease in net taxes results in: a.A decrease in Y, a decrease in r, and an increase in I. b.An increase in Y, an increase in r, and a decrease in I. c.An increase in Y, a decrease in r, and an increase in I. d.A decrease in Y, an increase in r, and a decrease in I.

33. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 33 of 45 COMBINING THE GOODS MARKET AND THE MONEY MARKET Contractionary Monetary Policy: A Decrease in the Money Supply contractionary monetary policy A decrease in the money supply aimed at decreasing aggregate output (income) (Y). Effects of a contractionary monetary policy:

34. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 34 of 45 COMBINING THE GOODS MARKET AND THE MONEY MARKET policy mix The combination of monetary and fiscal policies in use at a given time. THE MACROECONOMIC POLICY MIX TABLE 12.1 The Effects of the Macroeconomic Policy Mix FISCAL POLICY Monetary Policy

35. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 35 of 45 Which policy mix favors investment spending over government spending? a.Expansionary fiscal policy and contractionary monetary policy. b.An increase in the money supply and a fall in government purchases. c.Both expansionary fiscal policy and expansionary monetary policy. d.None of the above. No policy mix favors investment over government spending.

36. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 36 of 45 Which policy mix favors investment spending over government spending? a.Expansionary fiscal policy and contractionary monetary policy. b.An increase in the money supply and a fall in government purchases. c.Both expansionary fiscal policy and expansionary monetary policy. d.None of the above. No policy mix favors investment over government spending.

37. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 37 of 45 OTHER DETERMINANTS OF PLANNED INVESTMENT The determinants of planned investment are ■The interest rate ■Expectations of future sales ■Capital utilization rates ■Relative capital and labor costs

38. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 38 of 45 The demand for investment shifts to the right when: a.The interest rate decreases. b.Entrepreneurs are optimistic about future sales. c.Capital utilization rates are low. d.Labor is less expensive relative to capital.

39. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 39 of 45 The demand for investment shifts to the right when: a.The interest rate decreases. b.Entrepreneurs are optimistic about future sales. c.Capital utilization rates are low. d.Labor is less expensive relative to capital.

40. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 40 of 45 contractionary fiscal policy contractionary monetary policy crowding-out effect expansionary fiscal policy expansionary monetary policy goods market interest sensitivity or insensitivity of planned investment money market policy mix REVIEW TERMS AND CONCEPTS

41. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 41 of 45 THE IS-LM DIAGRAM Appendix A THE IS CURVE An IS curve illustrates the negative relationship between the equilibrium value of aggregate output (income) (Y) and the interest rate in the goods market. FIGURE 12A.1 The IS Curve

42. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 42 of 45 Appendix A THE LM CURVE An LM curve illustrates the positive relationship between the equilibrium value of the interest rate and aggregate output (income) (Y) in the money market. FIGURE 12A.2 The LM Curve

43. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 43 of 45 Appendix A 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. FIGURE 12A.3 The IS-LM Diagram

44. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 44 of 45 Appendix A FIGURE 12A.4 An Increase in Government Purchases (G)

45. CHAPTER 12: Money, the Interest Rate, and Output: Analysis and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 45 of 45 Appendix A FIGURE 12A.5 An Increase in the Money Supply (M s )