Money, the Interest Rate, and Output: Analysis and Policy - PowerPoint PPT Presentation

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

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

  2. 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. • This chapter examines how monetary and fiscal policies affect the level of output, interest rates, and investment spending.

  3. 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. • An increase in aggregate output (income) shifts the money demand curve, which raises the equilibrium interest rate from 7 percent to 14 percent.

  4. 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 falls, planned investment rises, and when the interest rate rises, planned investment falls (fewer projects are likely to be undertaken).

  5. 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 Y0 to Y1.

  6. 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.

  7. 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).

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

  9. r decreases less than if Md did not increase. 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 higher level of Y increases the demand for money, and this keeps the interest rate from falling as far as it otherwise would.

  10. Effectiveness of Monetary Policy • 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.

  11. 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.

  12. 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.

  13. 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).

  14. Y decreases less than if r did not decrease. Contractionary Policy Effects • The decrease in Y would be less than it would be if we did not take the money market into account.

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

  16. Y decreases less than if r did not decrease. 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.

  17. The Effects of the Macroeconomic Policy Mix FISCAL Expansionary( G or T) Contractionary( G or T) Expansionary Y , r ?, I ?, C Y ?, r , I , C ? ( Ms) MONETARY 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

  18. 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:

  19. 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 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.

  20. 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.

  21. 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.

  22. 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.

  23. Appendix: The IS-LM Diagram • 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.

  24. 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. • 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.