RETP A HC 12

Money, the Interest Rate, and

Output: Analysis and Policy
Appendix: The IS-LM Diagram

Prepared by: Fernando Quijano

and Yvonn Quijano

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair
 The Goods Market
and 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.
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• 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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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 2 of 29
 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.

• This chapter examines how

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monetary and fiscal policies affect

the level of output, interest rates, and
investment spending.
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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 3 of 29
 The Links Between the Goods
Market and the Money Market

• Planned investment depends on the

interest rate and money demand
depends on income.
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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 4 of 29
 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.
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• When income falls, the

demand for money falls
and the interest rate falls.
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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 5 of 29
 Link 2: Planned Investment
and the Interest Rate

• The interest rate, which is

determined in the money
market, has significant
effects on planned
investment in the goods
market.
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• When the interest rate

rises, planned investment
falls (fewer projects are
likely to be undertaken).
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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 6 of 29
 Investment, the Interest Rate
and the Goods Market

• An increase in the
interest rate from 3
percent to 6 percent
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lowers planned aggregate

expenditure and thus
reduces equilibrium
income from Y0 to Y1.
↑ r → I↓ → A ↓E → Y↓
↓r → I↑ → ↑E → Y↑
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A
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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 7 of 29
 Equilibrium in the Money Market
(review)
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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 8 of 29
 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
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rate.

Y ↑ → M d
↑ → r↑
Y ↓ → M d
↓ → r↓
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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 9 of 29
 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).
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ycil oP dna si s yl an A

• Expansionary monetary policy is

an increase in the money supply
aimed at increasing aggregate
output (income) (Y).
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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 10 of 29
 The Crowding-Out Effect

• The crowding-out
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effect is the tendency

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for increases in
government spending
to cause reductions in
↑ G → Y↑ → M d
↑ → r↑ → I ↓ private investment
spending.
Y increases less than if r did not increase
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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 11 of 29
 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

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planned investment spending

changes a great deal in response to
changes in the interest rate.
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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 12 of 29
 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
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money keeps the interest rate

from falling as far as it
otherwise would.

↑ M s
→ r↓ → I ↑ → Y↑ → M d
↑
r decreases less than if Md did not increase
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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 13 of 29
 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
At aHRCt s er et nI eht , y eno M
ycil oP dna si s yl an A

shift the money demand

curve to the right, and put
upward pressure on the
interest rate.
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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 14 of 29
 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
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“accommodate” the fiscal

expansion, the interest rate
would not rise.
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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 15 of 29
 Contractionary Policy Effects

• Contractionary fiscal
policy refers to a
decrease in
government spending
or an increase in net
taxes aimed at
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decreasing aggregate
output (income) (Y).

G ↓ o T r↑ → Y↓
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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 16 of 29
 Contractionary Fiscal Policy

• The decrease in Y is
smaller when we take
the money market into
account.
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G ↓ o T r↑ → Y↓ → M d
↓ → r↓ → I ↑
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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 17 of 29
 Contractionary Monetary Policy

• Contractionary monetary
policy refers to a decrease
in the money supply aimed
at decreasing aggregate
output (income) (Y).
At aHRCt s er et nI eht , y eno M
ycil oP dna si s yl an A

M s
↓ → r↑ → I↓ → ↓Y
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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 18 of 29
 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.
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ycil oP dna si s yl an A

M s
↓ → r↑ → I ↓ → Y↓ → M d
↓
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Y decreases less than if r did not decrease

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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 19 of 29
 The Macroeconomic Policy Mix

The Effects of the Macroeconomic Policy Mix

FISCAL POLICY
Expansionary Contractionary
( G or T) ( G or T)
Expansionary Y , r ?, I ?, C Y ?, r , I , C ?
( Ms)
MONETARY
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POLICY Contractionary Y ?, r , I , C ? Y , r ?, I ?, C
( Ms)
Key:
: Variable increases.
: Variable decreases.
?: Forces push the variable in different directions. Without additional
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information, we cannot specify which way the variable moves.

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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 20 of 29
 Other Determinants of
Planned Investment

The determinants of planned

investment are:
• The interest rate
• Expectations of future sales
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• Capital utilization rates

• Relative capital and labor costs
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