MONEY, INTEREST AND

INCOME
 Investment and Interest Rate
 The main determinant of AD that is susceptible
to interest rate changes is investment (I).

 It is the cost of borrowed funds used to finance

investment by firms.

 So if interest rate rises, cost of borrowing

increases, as a result, it lowers the inducement
to invest.
 Therefore, if ‘i’ increases, ‘I’ falls.
 IS CURVE
 IS-LM model criticised by many economists.
Some say it’s outdated.

 But more pragmatic economists like Mankiw

defended the IS-LM model strongly.

 IS curve shows the relationship between

interest rates and income, that is, it shows the
equilibrium in the goods market.
 IS Curve
 IS: Investment = Savings

 Lets assume, investment is no more exogenous.

It is endogenous.
 Therefore, I= I (Y, i).
 Y rises, I rises. ‘i’ rises, ‘I’ decreases.
 Any point along the IS curve is an equilibrium
of the goods market. It includes all the
combinations of interest rates and output
where this I= S holds true (or in other words,
demand= production).
 Slope of IS Curve
 The magnitude of the increase in investment
demand due to a fall in interest rate depends
on the interest sensitivity of investment
demand.

 The change in output is affected by interest

rates, that is, slope of the IS curve depends on:
the interest sensitivity of investment (h), the
marginal propensity to consume (c), and the
tax rate, (t).
 Slope of IS Curve
 Increase in ‘h’ reduces the absolute value of the
slope implying a flatter IS curve. We get a flatter
IS curve when ‘c’ increases or when ‘t’ is reduced.

 Figure 5.4 (page 121)- The marginal propensity to

consume and the slope of the IS curve.
 An increase in ‘c’ increases the multiplier, which
in turn increases the income. AD shifts anti-
clockwise, output goes up and the IS also shifts
and is flatter.
 Shift of IS curve
 If ‘G’ increases, IS shifts right. If taxes increase,
IS shifts left (for any given interest rate).
 For any increase in ΔG, the shift in equilibrium
income is equal to μΔG. μ is the multiplier
effect.

 Figure 5.5

 The amount of the shift or the increase in

equilibrium income at either interest rate is
equal to μΔḠ.
 Points off the IS curve
 Figure 5.6:
 Points to the right of IS curve implies excess
supply compared to demand, so there is an
increase in unintended inventory investment.
Firms need to cut back their production. So, the
economy moves back to E1.

 Points to the left of IS curve implies excess

demand compared to supply. So, to meet this
demand, firms give away their unintended
investment, and starts to produce more. So output
moves from Y1 to Y2, point E2.
 LM CURVE
 This curve illustrates the equilibrium in the money market
(i.e. Financial market equilibrium).

 Money is dependent on two things- income and interest

rates.

 Income increases, need for transaction increases, so demand

for money increases. This is known as transactions demand
for money.

 Interest rates increase, the opportunity cost of holding money

and not investing in bonds increase, so demand for money
decreases (negative relationship)- Speculative demand for
money.
 LM Curve
 The LM curve slopes upward because a rise in
income increases the demand for money, which
in turn requires the interest rate to rise because
the rise in interest rate reduces the speculative
demand for money by an equal amount,
thereby bringing the money market back to
equilibrium.
 LM Curve (Slope and Position)

 A one dollar increase in income increases the

demand for money by ‘k’ dollars, and a 1% increase
in interest rate reduces the money demand by ‘l’
dollars.

 The slope of the LM depends on two parameters, k

and l.
 The greater the sensitivity of demand for money to
changes in income, as measured by k, and the lower
the responsiveness of demand to interest rates, the
greater the slope of demand for money.
 LM Curve
 An increase in ‘k’ implies that any real income
now requires a larger transaction balance will
have to be spent from speculative balance of
money. In order to induce people to spend this
additional amount, the interest rate has to go
up by a greater amount. Therefore, LM curve is
steeper.
 Points off the LM curve
 All points above and to the left of the LM curve
represent points of excess supply of money in
the money market.

 All points below the LM curve represent excess

money demand.
 Shifts in the LM curve
 LM curve shifts for two reasons:

 Money supply in the economy- Money supply

increases, LM shifts rightwards.

 Price level changes in the economy- Price level

increases, people start making less transactions,
so money supply decreases, LM shifts
leftwards.
Adjustments in the money market
 Figure 5.13:
 At E4, demand for money exceeds supply. This
also means, supply of bonds exceeds demand.
In order to reduce the bonds supply and
increase money supply, people start selling
bonds. This drives down the price of bonds and
raises the interest rate until people are willing
to hold the existing supply of money and
bonds.
Adjustments in the money market
 Figure 5.13:
 At E3, supply of money is higher. This implies
a higher demand for bonds. Bond prices rise,
which in turn decreases the interest rate to
move down until the economy is in
equilibrium.

 Thus, if there is a disequilibrium in the money

market, the interest rate adjusts to reach
equilibrium.
 Velocity of Money
 The frequency at which the average unit of
currency is used to purchase newly domestically-
produced goods and services within a given time
period.
 It is the number of times one dollar is spent to buy
goods and services per unit of time.

 Interest rate in the economy affects velocity of

money. An increase in ‘i’ raises the opportunity
cost of holding money, encouraging people to hold
more bonds than money. So people economise on
holding money. The velocity increases.
 Velocity of Money

 Economies that exhibit a higher velocity of

money relative to others tend to be further
along in the business cycle and should have a
higher rate of inflation, all things held constant.
Velocity rises as we move up along the LM
curve.