Money, the Interest Rate, and Output: Analysis and Policy
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.
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.
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).
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 equilibrium income from Y0 to Y1.
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 rate.
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).
The Crowding-Out Effect The tendency for increases in government spending to cause reductions in private investment spending is called the crowding-out effect.
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.
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.
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.
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.
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).
Contractionary Monetary Policy
Contractionary monetary policy refers to a decrease in the money supply aimed at decreasing aggregate output (income) (Y).
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
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.
- 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 rat
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.
- 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.
- 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.