Money, the Interest Rate, and Output: Analysis and Policy

1. Money, the Interest Rate, and Output: Analysis and Policy Appendix: The IS-LM Diagram Prepared by: Fernando Quijano and Yvonn Quijano

2. The Goods Marketand the Money Market • The goods market is the market in which goods and services are exchanged and in which the equilibrium level of aggregate output is determined. • The money market is the market in which financial instruments are exchanged and in which the equilibrium level of the interest rate is determined.

3. The Links Between the GoodsMarket and the Money Market • 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.

4. THE LINKS BETWEEN THE GOODS MARKETAND 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. The Links Between the GoodsMarket and the Money Market • Planned investment depends on the interest rate and money demand depends on income.

6. 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. • When income falls, the demand for money falls and the interest rate falls.

7. Link 2: Planned Investmentand the Interest Rate • The interest rate, which is determined in the money market, has significant effects on planned investment in the goods market. • When the interest rate rises, planned investment falls (fewer projects are likely to be undertaken).

8. Investment, the Interest Rateand the Goods Market • An increase in the interest rate from 3 percent to 6 percent lowers planned aggregate expenditure and thus reduces equilibrium income from Y0 to Y1.

9. THE LINKS BETWEEN THE GOODS MARKETAND 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:

10. Equilibrium in the Money Market (review)

11. Money Demand, Aggregate Output (Income), and 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.

12. THE LINKS BETWEEN THE GOODS MARKETAND 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:

13. 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 monetary policy is an increase in the money supply aimed at increasing aggregate output (income) (Y).

14. The Crowding-Out Effect • The crowding-out effect is the tendency for increases in government spending to cause reductions in private investment spending. Y increases less than if r did not increase

15. The Crowding-Out Effect • The crowding-out effect depends on the sensitivity or insensitivity 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.

16. Expansionary Monetary Policy:An Increase in the Money Supply • An increase in the money supply decreases the interest rate and increases investment and income. • However, the simultaneous increase in the demand for money keeps the interest rate from falling as far as it otherwise would. r decreases less than if Md did not increase

17. Fed Accommodation of an Expansionary Fiscal Policy • An expansionary fiscal policy (higher government spending or lower taxes) will increase aggregate output (income). • In turn, higher income will shift the money demand curve to the right, and put upward pressure on the interest rate.

18. Fed Accommodation of an Expansionary Fiscal Policy • If the money supply were unchanged following an increase in the demand for money, the interest rate would rise. • But if the Fed were to “accommodate” the fiscal expansion, the interest rate would not rise.

19. 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).

20. Contractionary Fiscal Policy • The decrease in Y is smaller when we take the money market into account.

21. Contractionary Monetary Policy • Contractionary monetary policy refers to a decrease in the money supply aimed at decreasing aggregate output (income) (Y).

22. Contractionary Monetary Policy • When we take into account the money market, the interest rate will increase by less, and the decrease in Y will be smaller. Y decreases less than if r did not decrease

23. The Effects of the Macroeconomic Policy Mix FISCAL POLICY Expansionary( G or T) Contractionary( G or T) Expansionary Y , r ?, I ?, C Y ?, r , I , C ? ( Ms) MONETARYPOLICY Contractionary Y ?, r , I , C ? Y , r ?, I ?, C ( Ms) Key: : Variable increases. : Variable decreases. ?: Forces push the variable in different directions. Without additionalinformation, we cannot specify which way the variable moves. The Macroeconomic Policy Mix

24. Other Determinants ofPlanned Investment • The interest rate • Expectations of future sales • Capital utilization rates • Relative capital and labor costs The determinants of planned investment are:

25. Review Terms and Concepts 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

26. 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.

27. Appendix: The IS-LM Diagram • 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.

28. Appendix: The IS-LM Diagram • 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). • The LM curve is upward-sloping because higher income results in higher demand for money and a higher interest rate.

29. 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.

30. Appendix: The IS-LM Diagram • An increase in government spending shifts the IS curve to the right. • This increases the value of both Y and r.

31. Appendix: The IS-LM Diagram • An increase in the money supply shifts the LM curve to the right. • In turn, the value of Y increases and the value of r decreases.

32. 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. • Here, 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.