1

CHAPTER 23

Money, the Interest Rate, and

Output: Analysis and Policy

Prepared by: Fernando Quijano

and Yvonn Quijano

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Links Between the Goods Market
and the Money Market
• The goods and money markets do not
operate independently. 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.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 2
 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.
• An increase in aggregate
output (income) shifts the
money demand curve,
which raises the
equilibrium interest rate
from 7 percent to 14
percent.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 3
 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.
• When the interest rate
falls, planned investment
rises, and when the
interest rate rises, planned
investment falls (fewer
projects are likely to be
undertaken).

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 4
 The Interest Rate and Planned
Aggregate Expenditure

• An increase in the
interest rate from 3
percent to 6 percent
lowers planned
aggregate
expenditure and
thus reduces
 r  I   AE   Y  equilibrium income
from Y0 to Y1.
 r  I   AE   Y 
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 5
 Money Demand, Aggregate Output
(Income), and the Money Market
• The equilibrium interest
rate is not determined
exclusively in 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
Y   Md   r 
rate.
Y   Md   r 

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 6
 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).

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 7
 The Crowding-Out Effect

• The tendency for increases

in government spending to
cause reductions in private
investment spending is
 G  Y  M   r  I 
d

Y increases less than if r did not

called the crowding-out
increase effect.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 8
 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 higher level of
Y increases the demand for
money, and this keeps the
interest rate from falling as
far as it otherwise would.
 Ms  r   I   Y   Md 
r decreases less than if Md did not
increase.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 9
 Effectiveness of Monetary Policy

• The effectiveness of monetary policy

depends on the shape (or responsiveness)
of the investment function.
• The steeper the investment
function, the less responsive
investment is to changes in
interest rates. This lack of
responsiveness may render
monetary policy ineffective.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 10
 Fed Accommodation of an
Expansionary Fiscal Policy
• An expansionary fiscal
policy (higher government
spending or lower taxes)
will increase aggregate
output (income), shift the
money demand curve to
the right, and put upward
pressure on the interest
rate.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 11
 Fed Accommodation of an
Expansionary Fiscal Policy
• If the money supply were
unchanged, the interest rate
would rise. But if the Fed
were to “accommodate” the
fiscal expansion, the
interest rate would not rise.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 12
 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  or T   Y 

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 13
 Contractionary Policy Effects

• The decrease in Y would be less than it would be if we

did not take the money market into account.
G  or T   Y   M d   r   I 
Y decreases less than if r
did not decrease.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 14
 Contractionary Monetary Policy

• Contractionary monetary policy refers to a

decrease in the money supply aimed at
decreasing aggregate output (income) (Y).
Ms   r  I 

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 15
 Contractionary Monetary Policy

• The increase in the interest rate will be less than it

would be if we did not take the goods market into
account.
Ms   r   I   Y   Md 
Y decreases less than if r did not decrease.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 16
 The Macroeconomic Policy Mix

The Effects of the Macroeconomic Policy Mix

FISCAL
Expansionary Contractionary
( G or T) ( G or T)
Expansionary Y , r ?, I ?, C Y ?, r , I , C ?
( Ms)
MONETARY
Contractionary Y ?, r , I , C ? Y , r ?, I ?, C
( Ms)
Key:
: Variable increases.
: Variable decreases.
?: Forces push the variable in different directions. Without additional
information, we cannot specify which way the variable moves.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 17
 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

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 18
 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.
• 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.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 19
 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.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 20
 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.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 21
 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.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 22
 Appendix: The IS-LM Diagram

• An increase in the money

supply shifts the LM curve
to the right.
• This increases the value of
Y and decreases the value
of r.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 23
 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.
• For example, 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.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 24