Presentation on theme: "Outline Investment and the Interest Rate"— Presentation transcript:
0 Financial Markets and Aggregate Demand Chapter 8
1 Outline Investment and the Interest Rate Net Exports and the Interest RateThe Demand for and Supply of MoneyThe IS Curve and the LM CurvePolicy Analysis with IS-LMThe Aggregate-Demand CurveDetermination of Output and Unemployment in the Short Run
2 8.1. Investment and the Interest Rate Investment depends negatively on interest rates. Why?Most investments are financed through borrowing or with funds from selling financial securities. If interest rates are high, then there are high borrowing costs or high losses in incomeInvestment function:I = e - dRe, d = constantsd = how much investment falls when the interest rate increases by 1%
4 Investment and the Interest Rate By making investment endogenous, we have introduced a new endogenous variable: the interest rate, RWe focus here on the average interest rate (which represents the behavior of all the different types of rates: long-term, short-term securities, etc.)Note: distinguish between real and nominal interest rates:Real interest rate (R) = Nominal interest rate (i) – Inflation real interest rate: RHere we use the real interest rate: R
5 8.2. Net Exports and the Interest Rate Net exports depend negatively on the interest rate. Why?If U.S. interest rates are higher than rates in other countries, dollars become more attractive, which drive up the price of dollars; U.S. goods become more expensive and foreign goods cheaper, thus net exports fallX = g – mY -- nRn – measures the decrease in net exports when the interest rate rises by 1%
6 8.3. The Demand for and Supply of Money Money is:Currency issued by the Federal Reserve (coins, dollar bills) together with checking account balances held by public in banksIt does not include larger amount of wealth, such as mutual funds, bonds, corporate stock, etc.
7 The Demand for MoneyPeople want to hold less money when the interest rate is high and more money when the interest rate is low.People want to hold more money when income is higher and less money when income is lower.People want to hold more money when price level is higher and less money when price level is lower.
8 The Demand for Money M – demand for money R – interest rate Money demand functionM = (kY – hR)PM – demand for moneyR – interest rateP – price levelk, h – coefficientsk – how much money demand increases when income increasesh – how much money demand declines when interest rate raises
9 The Supply of MoneyMoney Supply level – determined by the Federal Reserve SystemFor now, we assume that the Fed picks a certain level, MIn the short-run model, when prices are predetermined, income and interest rates adjust to keep the demand for money equal to its fixed supply
10 8.4. The IS Curve and the LM Curve Five relations in the IS – LM frameworkY = C + I + G + XC = a + b(1-t)YI = e – dRX = g – mY - nRM = (kY – hR)PEndogenous variables: Y, C, I, X, and RExogenous variables: G and MPredetermined variable: P
11 a) The IS CurveThe IS curve shows all combinations of R and Y that satisfy the income identity, the consumption function, the investment function, and the net- export function.It is the set of points for which spending balance occurs.When the curve slopes downward -- higher interest rate reduces investment and net exports and thereby reduces GDP through the multiplier processShifts: an increase in government spending increases GDP through the multiplier and shifts the IS curve to the right
13 FIGURE 8.3 GRAPH DERIVATION OF THE IS CURVE 45º lineSPENDING6,100 –6,000 –5,900 –5,800 –Old spending lineNew spending line5, , , , ,200GDP (Y)INTEREST RATE8 –New interest rate7 –6.2 ––5 –Old interest rate4 –3 –New Level of GDPOld Level of GDPIS Curve2 –1 –5, , , , ,200GDP (Y)
14 The LM CurveThe LM curve shows all combinations of R and Y that satisfy the money demand relationship for a fixed level of the money supply and a predetermined value of the price level.When the curve slopes upward: if the interest rate increases, money demand decreases; therefore, to have equilibrium in the money market there should be an increase in income. So, an interest-rate increase is associated with a rise in income.
15 The LM CurveNote: Real money = money supply M divided by price level PM/P = kY – hRThe demand for real money depends positively on real GDP and negatively on the interest rateShifts: an increases in money supply shifts the LM curve to the right
18 Algebraic Derivation of the IS and LM Curves IS curve:LM curve:To satisfy all five relationships of the model, the values of R and Y must be on both the IS curve and the LM curve; that is, at their intersection (next figure)
19 FIGURE 8.6 THE INTERSECTION OF THE IS CURVE AND THE LM CURVE INTEREST RATE (R) (%)10 –5 –LMIS5, , , , ,200GDP (Y)
20 8.5.Policy Analysis with IS-LM Monetary Policy: changes in the money supplyWhat happens in the economy when the Fed increases the money supply?Immediately after the increase, more money is in the economy than people demand. This makes the interest rate fall, so the demand for money increases.The lower interest rate stimulates investment and net exports.This raises GDP through the multiplier process; GDP rises and the interest rate fallsLM curve shifts to the right (increase in real money)
21 Policy Analysis with IS-LM Fiscal Policy: the use of tax rates and government spending to influence the economyEx. Congress passes a bill that increases government spending or decrease in taxesAn increase in government spending increases the interest rate (through the increase in the demand for money) and increases income (through the multiplier)Increasing the interest rate reduces investment and net exports, thereby offsetting some of the increase in income – crowding out
22 Policy Analysis with IS-LM These are short-run results with the price level predetermined. When the time frame is lengthened in the next chapter, so that the price level can adjust, these results will have to be modified.
23 FIGURE 8.7 EFFECTS OF MONETARY AND FISCAL POLICIES INTEREST RATE (R) (%)INTEREST RATE (R) (%)10 –9 –8 –7 –6 –5 –4 –3 –2 –1 –10 –9 –8 –7 –6 –5 –4 –3 –2 –1 –IS curve shifts rightLMOld LMLM curve shifts rightNew LMInterest rate risesInterest rate fallsNew ISGDP risesISOld ISGDP rises5, , , , ,2005, , , , ,200GDP (Y)GDP (Y)Old level of GDPNew level of GDPOld level of GDPNew level of GDPIncrease in Money SupplyIncrease in Government spending
24 8.6 The Aggregate Demand Curve The AD curve shows combinations of price levels and output where the IS and LM curves intersect, or where spending balance occurs and money demand equals money supply.Note: Even though they look similar, the ideas behind the aggregate demand curve are much different from those that underlie the typical demand curve of microeconomics.The financial system — the demand for and supply of money lies behind the aggregate demand curve.
25 The Aggregate Demand Curve The AD curve slopes downward; therefore, a decrease in prices increases real money, shifting the LM curve to the right, lowering interest rates, increasing investment and increasing output.
27 FIGURE 8.9 DERIVATION OF THE AD CURVE INTEREST RATE (R) (%)New LM8 –Old LM7 –6 –5 –4 –3 –IS2 –1 –5, , , , ,200GDP (Y)PRICE LEVEL (P)1.15 –1.10 –1.05 –1.00 –.95 –.90 –New price levelOld price levelAD5, , , , ,200GDP (Y)New level of GDPOld level of GDP
28 The Aggregate Demand Curve Changes in the money supply and in government spending both shift the aggregate demand curve.Monetary PolicyAn increase in M at a given price level results in an increase in aggregate demandRationale? More money means that a lower interest rate equates money demand with money supply. A lower interest rate stimulates more investment and net exports, which in turn require a higher level of GDP for spending balanceThe aggregate demand curve shifts to the right when the money supply increases
29 The Aggregate Demand Curve Fiscal policyAn increase in government spending shifts the aggregate demand curve to the right.At a given price level, more government spending means more aggregate demand.
30 8.7. Determination of Output in the Short Run Recall: Prices are sticky; they take some time to adjust in response to demand conditions.The level of output at a predetermined price level is determined by the point on the aggregate demand curve corresponding to the price level.In the short run, output can be above or below its potential level.
31 FIGURE 8.10 DETERMINATION OF OUTPUT WITH A PREDETERMINED PRICE PRICE LEVEL (P)PRICE LEVEL (P)Predetermined-price linePredetermined-price lineP0P0Aggregate demand curve (AD)New ADOld AD5, ,200Y0Y0Y1GDP (Y)5, ,200GDP (Y)
33 8.7. Determination of Unemployment in the Short Run If GDP declines, most workers who are laid off become unemployed (and it becomes harder for people who are looking for work to find jobs).Because of the importance of hours reductions and the common pattern of retaining workers during temporary declines in demand (called labor hoarding), a 3 percent decline in GDP is associated with only a 1 percentage point increase in unemployment (Okun’s Law).
34 FIGURE 8.12 DETERMINATION OF EMPLOYMENT PRICEThe AD curve shifts inwardY declines from Y* to Y’ADAD’Y’Y*GDP% GDP GAPGDP gap% GDP GAPOkun’s law(Y – Y*)/Y* declines from 0 to a negative amountOkun’s law shows how much unem-ployment rises-3.6%5, ,000U*U’GDP6%7.2%UNEMPLOYMENT RATE
35 Numerical Example Consider the following economy : Y = C + I + G + X C = YdI = 200 – 500RX = 100 – 0.12Y – 500RM = (0.8Y -2000R)PG = $200, t = 0.2, M = $800, P = 1Yd = Y - 0.2YNote: All quantities are in billions of dollars
36 Numerical Example What is the IS curve? Substitute C, I and X in the income identity:Y = (Y-0.2Y) – 500R Y – 500RY = Y -1000R0.4Y = 600 – 1000RIS curve: Y = 1500 – 2500R
37 Numerical Example What is the LM curve? Derive from the equation for money demand:M = (0.8Y -2000R)P800 = 0.8Y R,0.8Y = RSo LM curve: Y = R
38 Numerical ExampleWhat are the values of income and interest rate if spending balance occurs and the demand for money equals the supply for money?Y (from IS curve) = Y (from LM curve)1500 – 2500R = R500 = 500RR = 0.10 (10%)Substitute R into IS or LM: Y = 1250
39 Numerical ExampleWhat are the values of consumption, investment and net exports?C = 1000I = 150X = 100
40 Numerical Example Derive the aggregate demand curve: 1) To derive the effects of increases in government spending or real money on income, start with the equation for the LM curve, do not substitute a specific value for real money, and solve for output.M/P = 0.8Y-2000RY = 1.25 (M/P) R
41 Numerical Example Derive the aggregate demand curve: 2) Now use the income identity, substitute the consumption, investment and net export equations, but not a specific value for government spending, and solve for 2500 times the interest rate:Y = (Y-0.2Y) – 500R + G Y – 500RY = Y – 1000R + G1000R = 400 – 0.4Y + G2500R = 1000 – Y +2.5G
42 Numerical Example Derive the aggregate demand curve: 3) Then substitute the spending balance equation into the LM curve, and solve for YY = 1.25 (M/P) – Y +2.5G2Y = 1.25 (M/P) GAD curve: Y = 0.625(M/P) G
43 Numerical ExampleHow much does an increase in government spending or real money of $100 bill increase GDP?AD curve: Y = 0.625(M/P) GAn increase in government spending of 100 raises real GDP by 125. An increase in the money supply of 100, with the price level constant, raises real GDP by 62.5.