12 © 2004 prentice hall business publishingprinciples of economics, 7/ekarl case, ray fair money,...

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© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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

Appendix: The IS-LM Diagram

Prepared by: Fernando QuijanoPrepared by: Fernando Quijano and Yvonn Quijano and Yvonn Quijano

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2 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

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.

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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.

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The Links Between the GoodsMarket and the Money Market

• Planned investment depends on the interest rate and money demand depends on income.

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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.

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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).

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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. r I A E Y

r I A E Y

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Equilibrium in the Money Market (review)

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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.

Y M rd

Y M rd

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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).

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The Crowding-Out Effect

• The crowding-out effect is the tendency for increases in government spending to cause reductions in private investment spending.

G Y M r Id

Y increases less than if r did not increase

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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.

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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.

M r I Y Ms d

r decreases less than if Md did not increase

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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.

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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.

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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).

G o r T Y

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Contractionary Fiscal Policy

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

G M r Id o r T Y

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Contractionary Monetary Policy

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

M r Is Y

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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.

M r I Y Ms d

Y decreases less than if r did not decrease

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The Macroeconomic Policy Mix

( Ms)

Forces push the variable in different directions. Without additionalinformation, we cannot specify which way the variable moves.

?:

Variable decreases.:

Variable increases.:

Key:

Y , r ?, I ?, CY ?, r , I , C ?Contractionary

MONETARYPOLICY

( Ms)

Y ?, r , I , C ?Y , r ?, I ?, C Expansionary

Contractionary( G or T)

Expansionary( G or T)

FISCAL POLICY

The Effects of the Macroeconomic Policy Mix

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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:

12 © 2004 prentice hall business publishingprinciples of economics, 7/ekarl case, ray fair money,...

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