Chapter Twenty Eight Money, the Interest Rate, and Output: Analysis and Policy

Links Between the Goods Market and the Money Market 4 Income 4 Income, which is determined in the goods market, has considerable influence on the demand for money in the money market. interest rate 4 The interest rate, which is determined in the money market, has significant effects on planned investment in the goods market.

Planned Investment Schedule Interest Rate Planned Investment 5% 15% 10% I0I0 I1I1 I2I2

The Effects of a Change in the Interest Rate 4 A high interest rate (r) discourages planned investment (I) 4 Planned investment is part of planned aggregate expenditure (AE) 4 When the interest rate rises, planned AE at every level of income falls 4 The decrease in planned AE lowers equilibrium output (Y) by a multiple of the initial increase in planned I.

The Effect of an Interest Rate Increase on Planned AE Aggregate Output C+I 0 +G ( r=3%) Aggregate Planned Expenditures Y0Y0 C+I 1 +G (r=6%) Y1Y1 45 o

Equilibrium in the Money Market Interest Rate Money, M MdMd Md1Md1 Excess demand for money Excess supply of money MSMS

The effect of an increase in income (Y) on the interest rate (r)... Interest Rate 6 9 Money, M M 0 d (Y=Y 0 ) MSMS Excess demand for money M 1 d (Y=Y 1 )

Summary YMdMd r YIrAE YMdMd r YIr

Suppose Expansionary Fiscal Policy... 4 Fiscal policy which is aimed at increasing the level of equilibrium output 4 Increase in government expenditures 4 Decrease in taxes

Aggregate Output C+I 0 +G 0 (r=r 0 ) Aggregate Planned Expenditures Y0Y0

Aggregate Output C+ I 0 +G 0 (r=r 0 ) Aggregate Planned Expenditures Y1Y1 C+ I 0 +G 1 (r=r 0 ) Y0Y0 Expansionary Fiscal Policy G 1 > G 0

Aggregate Output C+ I 0 +G 0 (r=r 0 ) Aggregate Planned Expenditures Y1Y1 C+ I 0 +G 1 (r=r 0 ) Y0Y0 Increase in r will cause decrease in I I 1 < I 0 C+ I 1 +G 0 (r=r 1 )

What happened? 4 Increase G implies increase Y 4 Increase Y implies increase M d 4 Increase M d implies increase r 4 Increase r implies decrease I 4 Decrease I implies decrease AE Crowding Out

4 Increase in G leads to decrease in I 4 Y increases less than if r did not increase

Effects of an Expansionary Fiscal Policy: YMdMd r G I Effects of an Expansionary Monetary Policy: YMdMd r MSMS I but Y increases less than if r did not increase (but Y increases less than if r did not increase) but r decreases less than if M d did not increase (but r decreases less than if M d did not increase)

Fed Accommodation of an Expansionary Fiscal Policy Interest Rate r0r0 r 1 Money, M M0dM0d M0SM0S M1dM1d M1SM1S

Effects of a Contractionary Fiscal Policy: YMdMd r G I Effects of a Contractionary Monetary Policy: YMdMd r MSMS I but Y decreases less than if r did not decrease (but Y decreases less than if r did not decrease) but r increases less than if M d did not decrease (but r increases less than if M d did not decrease)

Policy Mix Policy mix Policy mix refers to the combination of monetary and fiscal policies in use at a given time.

Determinants of Planned Investment 4 The interest rate 4 Expectations of future sales 4 Capital utilization rates 4 Relative capital and labor costs

Review Terms & Concepts 4 Contractionary fiscal policy 4 Contractionary monetary policy 4 Crowding-out effect 4 Expansionary fiscal policy 4 Expansionary monetary policy 4 Goods market 4 Interest sensitivity of planned investment 4 Money market 4 Policy mix