Macroeconomics

Chapter 10 (Money, Interest, and Income)

1 | P a g e

Chapter Highlights:
The IS-LM model is the core of short-run
macroeconomics.
The IS curve describes the combinations of
income and interest rates at which the goods
market is at its equilibrium.
The LM curve describes the combinations of
income and interest rates at which the
money market is in equilibrium.
The IS and LM curves give AD.
Increases in government spending raise
output and interest rates.
Increases in the money supply raise
output and lower interest rates.
Monetary policy plays a central role in the
determination of income and employment.
Interest rates are a significant determinant
of aggregate spending, and the Federal
Reserve, which controls money growth and
interest rates, is the first intuition to be
blamed when economy gets into trouble.
There is a strong, but not absolute, link
between money growth and output growth.
Monetary policy works through the money
market to affect output and employment.
THE GOODS MARKET AND THE IS
CURVE
The desired or planned rate of
investment is lower the higher the interest
rate.
is the rate of interest
measures the responsiveness of investment
to interest rate.

denotes autonomous investment spending,

that is, investment spending that is
independent of both income and the rate of
interest.
The investment schedule is negatively
sloped to reflect the assumption that a
reduction in the interest rate increases the
profitability of additions to the capital stock
and therefore leads to a larger rate of
planned investment spending.
If investment is highly responsive to
the interest rate, a small decline in interest
rates will lead to a large increase in
investment, so the investment schedule is
almost flat.
If investment responds little to interest
rates, the investment schedule will be more
nearly vertical.
Changes in autonomous investment
spending,

, shift the investment schedule.

An increase in

means at each level of

interest rate, firms plan to invest at a higher
rate.
The IS curve is called the goods market
equilibrium.
The IS curve is negatively sloped, reflecting
the increase in AD associated with a
reduction in the interest rate.
The IS curve is negatively sloped because a
higher level of the interest rate reduces
investment spending, thereby reducing AD
and thus the equilibrium level of income.
The steepness of the curve depends on
how sensitive investment spending is to
changes in the interest rate and also depends
on the multiplier, G.
G and b large flatter IS
A shift in the IS curve is caused by a
change in autonomous spending,

.
The smaller the multiplier and the less
sensitive the investment spending is to
changes in the interest rate, the steeper the
IS curve.
The IS curve is shifted by changes in
autonomous spending, including an increase
in government purchases, shifts the IS curve
out to the right.
THE MONEY MARKET AND THE LM
CURVE
The LM curve is the money market
equilibrium.
The demand for money is a demand for
real money balances because people will hold
money for what it will buy.
The higher the price level, the more
nominal balances a person has to hold to be
able to purchase a given quantity of goods.
The demand for real balances depends on
the level of real income and the interest rate.
The demand for money depends on the
level of real income because individuals hold
money to pay for their purchases, which in
turn, depend on income.
The demand for money depends on the
cost of holding money rather than other
assets.
The higher the interest rate, the lower the
quantity of real balances demanded, given
the income.
An increase in income raises the demand
for money as shown by the rightward shift in
the money demand schedule.
The parameters k and h reflect the sensitivity
of the demand for real balances to the level
of income and the interest rate, respectively.
The LM schedule shows all combinations of
interest rates and levels of income such that
the demand for real balances is equal to the
supply.
An increase in the interest rate reduces
the demand for real balances.


Macroeconomics
Chapter 10 (Money, Interest, and Income)

2 | P a g e

Precautionary demand and Transaction
demand depends on income. (kY)
Speculative demand is the money set
aside for a chance of investment and
depends on .
Steeper LM when k is large and h is small
Flatter LM when k is small and h is large
Change in shifts the LM curve.
The real money supply is held constant
along the LM curve.
A change in the real money supply will
shift the LM curve.
An increase in the money supply shifts
the LM curve to the right.
The LM curve is positively sloped. Given the
fixed money supply, an increase in the level
of income, which increases the quantity of
money demanded, has to be accompanied by
an increase in the interest rate. This reduces
the quantity of money demanded and
thereby maintains money market equilibrium.
The LM curve is steeper when the demand
for money responds strongly to income and
weakly to interest rates.
EQUILIBRIUM IN THE GOODS AND
MONEY MARKETS
The interest rate and the level of output
are determined by the interaction of the
money (LM) and goods (IS) markets.
At point E (intersection of LM and IS),
interest rates and income levels are such that
the public holds the existing money stock and
planned spending equals output.
Exogenous variables are those whose
values are not determined within the system
being studied.
The equilibrium levels of income and
interest rate change when either the IS or
the LM curve shifts.
The AD schedule maps out the IS-LM
equilibrium holding autonomous spending
and the nominal money supply constant and
allowing prices to vary.
SUMMARY
The IS-LM model is the basic model of AD
that incorporates the money market as well
as the goods market. It lays particular stress
on the channels through which monetary and
fiscal policy affect the economy.
The IS curve shows combinations of interest
rates and levels of income such that the
goods market is in equilibrium. Increases in
the interest rate reduce AD by reducing
investment spending. Thus, at higher interest
rates, the level of income at which the goods
market is in equilibrium is lower: The IS
curve slopes downward.
The demand for money is the demand for
real balances. The demand for real balances
increases with income and decreases with
the interest rate, the cost of holding money
rather than other assets. With an
exogenously fixed supply of real balances,
the LM curve, representing money market
equilibrium, is upward-sloping.
The interest rate and the level of output
are jointly determined by simultaneous
equilibrium of the goods and money markets.
This occurs at the point of intersection of the
IS and LM curves.
Monetary policy affects the economy first
by affecting the interest rate and then by
affecting AD. An increase n the money supply
reduces the interest rate, increases
investment spending and AD, and thus
increases the equilibrium output.
The IS and LM curves together determine
the AD schedule.
Changes in monetary and fiscal policy
affect the economy through the monetary
and fiscal policy multipliers.