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Chapter 12: Money, the Interest Rate, and Output: Analysis and Policy

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Title: Chapter 12: Money, the Interest Rate, and Output: Analysis and Policy


1
Chapter 12 Money, the Interest Rate, and Output
Analysis and Policy
Appendix The IS-LM Diagram
2
Outline
  • The link between the goods market and the money
    market
  • Combining the goods market and the money market
  • (1) Expansionary policy (effects)
  • (2) Contractionary policy (effects)

3
Two Markets
  • The goods market
  • The money market

4
I. The Links Between the Goods Market 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.

5
I. The Links Between the Goods Market and the
Money Market
6
Link 1 Income and the Demand for Money
  • When income increases, what happens to the money
    market?

7
Link 1 Income and the Demand for Money
  • When income falls, what happens to the money
    market?

8
Link 2 Planned Investment and the Interest Rate
  • When the interest rate rises, planned investment
    falls (fewer projects are likely to be
    undertaken).

9
Link 2 Planned Investment and the Interest Rate
  • 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.

10
II. (1) Expansionary Policy Effects
  • Expansionary fiscal policy
  • Expansionary monetary policy

11
(1) Expansionary Policy Effects 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
12
The Crowding-Out Effect
  • The crowding-out effect depends on the
    sensitivity or insensitivity of planned
    investment spending to changes in the interest
    rate.

13
Fed Accommodation of an Expansionary Fiscal Policy
  • An expansionary fiscal policy (higher government
    spending or lower taxes) will increase aggregate
    output (income).
  • 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.

14
Expansionary Monetary Policy
  • An increase in the money supply decreases the
    interest rate and increases investment and income.
  • However, the Fed can take actions to keep the
    interest rate from falling as far as it otherwise
    would.

r decreases less than if Md did not increase
15
II. (2) 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).

16
II. (2) Contractionary Fiscal Policy
  • The decrease in Y is smaller when we take the
    money market into account.

17
II (2) Contractionary Monetary Policy
  • Contractionary monetary policy refers to a
    decrease in the money supply aimed at decreasing
    aggregate output (income) (Y).

18
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
19
The Macroeconomic Policy Mix
20
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

21
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

22
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.

23
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.

24
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.

25
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.

26
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.

27
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.

28
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.
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