CHAPTER 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
Money, the Interest Rate, and Output:

• The goods market is the market in

which goods and services are
Analysis and Policy

exchanged and in which the

equilibrium level of aggregate output
is determined.

• The money market is the market in

C H A P T E R 12:

which financial instruments are

exchanged and in which the
equilibrium level of the interest rate
is determined.
© 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
Money, the Interest Rate, and Output:

• There is a value of output (income)

(Y) and a level of the interest rate (r)
Analysis and Policy

that are consistent with the existence

of equilibrium in both markets.

• This chapter examines how

monetary and fiscal policies affect
C H A P T E R 12:

the level of output, interest rates, and

investment spending.

© 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
Money, the Interest Rate, and Output:

• Planned investment depends on the

interest rate and money demand
Analysis and Policy

depends on income.
C H A P T E R 12:

© 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
Money, the Interest Rate, and Output:

• Income, which is
determined in the goods
market, has considerable
Analysis and Policy

influence on the demand

for money in the money
market.
• When income falls, the
C H A P T E R 12:

demand for money falls

and the interest rate falls.

© 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
Money, the Interest Rate, and Output:

• The interest rate, which is

determined in the money
market, has significant
Analysis and Policy

effects on planned
investment in the goods
market.
• When the interest rate
C H A P T E R 12:

rises, planned investment

falls (fewer projects are
likely to be undertaken).

© 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
Money, the Interest Rate, and Output:
Analysis and Policy

• An increase in the
interest rate from 3
percent to 6 percent
lowers planned aggregate
C H A P T E R 12:

expenditure and thus

reduces equilibrium
income from Y0 to Y1.
 r  I   AE   Y 
r  I   AE   Y 
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 7 of 29
 Equilibrium in the Money Market
(review)
Money, the Interest Rate, and Output:
Analysis and Policy
C H A P T E R 12:

© 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
Money, the Interest Rate, and Output:

• Changes in aggregate
output (income), which
take place in the goods
Analysis and Policy

market, shift the money

demand curve and cause
changes in the interest
rate.
C H A P T E R 12:

Y   M d
  r 
Y   M d
  r 
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 9 of 29
 Expansionary Policy Effects
Money, the Interest Rate, and Output:

• Expansionary fiscal policy is either

an increase in government spending
Analysis and Policy

or a reduction in net taxes aimed at

increasing aggregate output
(income) (Y).

• Expansionary monetary policy is

C H A P T E R 12:

an increase in the money supply

aimed at increasing aggregate
output (income) (Y).

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 10 of 29
 The Crowding-Out Effect
Money, the Interest Rate, and Output:
Analysis and Policy

• The crowding-out
effect is the tendency
for increases in
C H A P T E R 12:

government spending
to cause reductions in
 G  Y   M d
  r   I  private investment
spending.
Y increases less than if r did not increase
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 11 of 29
 The Crowding-Out Effect
Money, the Interest Rate, and Output:

• The crowding-out effect depends on

the sensitivity or insensitivity of
Analysis and Policy

planned investment spending to

changes in the interest rate.

• Interest sensitivity means that

planned investment spending
C H A P T E R 12:

changes a great deal in response to

changes in the interest rate.

© 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
Money, the Interest Rate, and Output:

• An increase in the money

supply decreases the interest
rate and increases
Analysis and Policy

investment and income.

• However, the simultaneous

increase in the demand for
money keeps the interest rate
C H A P T E R 12:

from falling as far as it

otherwise would.

 M s
 r   I   Y   M d

r decreases less than if Md did not increase

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 13 of 29
 Fed Accommodation of an
Expansionary Fiscal Policy
Money, the Interest Rate, and Output:

• An expansionary fiscal
policy (higher government
spending or lower taxes) will
Analysis and Policy

increase aggregate output

(income).
• In turn, higher income will
shift the money demand
C H A P T E R 12:

curve to the right, and put

upward pressure on the
interest rate.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 14 of 29
 Fed Accommodation of an
Expansionary Fiscal Policy
Money, the Interest Rate, and Output:

• If the money supply were

unchanged following an
increase in the demand for
Analysis and Policy

money, the interest rate

would rise.
• But if the Fed were to
“accommodate” the fiscal
C H A P T E R 12:

expansion, the interest rate

would not rise.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 15 of 29
 Contractionary Policy Effects
Money, the Interest Rate, and Output:

• Contractionary fiscal
policy refers to a
decrease in
Analysis and Policy

government spending
or an increase in net
taxes aimed at
decreasing aggregate
output (income) (Y).
C H A P T E R 12:

G  or T   Y 

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 16 of 29
 Contractionary Fiscal Policy
Money, the Interest Rate, and Output:

• The decrease in Y is
smaller when we take
the money market into
Analysis and Policy

account.
C H A P T E R 12:

G  or T   Y  M d
  r  I 
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 17 of 29
 Contractionary Monetary Policy
Money, the Interest Rate, and Output:

• Contractionary monetary
policy refers to a decrease
in the money supply aimed
Analysis and Policy

at decreasing aggregate
output (income) (Y).
C H A P T E R 12:

M s
  r   I  Y

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 18 of 29
 Contractionary Monetary Policy
Money, the Interest Rate, and Output:

• When we take into account

the money market, the
interest rate will increase
Analysis and Policy

by less, and the decrease

in Y will be smaller.
C H A P T E R 12:

M s
  r   I   Y   M d

Y decreases less than if r did not decrease
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 19 of 29
 The Macroeconomic Policy Mix
Money, the Interest Rate, and Output:

The Effects of the Macroeconomic Policy Mix

FISCAL POLICY
Expansionary Contractionary
Analysis and Policy

( G or T) ( G or T)
Expansionary Y , r ?, I ?, C Y ?, r , I , C ?
( Ms)
MONETARY
POLICY Contractionary Y ?, r , I , C ? Y , r ?, I ?, C
C H A P T E R 12:

( Ms)
Key:
: Variable increases.
: Variable decreases.
?: Forces push the variable in different directions. Without additional
information, we cannot specify which way the variable moves.
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 20 of 29
 Other Determinants of
Planned Investment
Money, the Interest Rate, and Output:

The determinants of planned

investment are:
Analysis and Policy

• The interest rate

• Expectations of future sales
• Capital utilization rates
C H A P T E R 12:

• Relative capital and labor costs

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 21 of 29
 Review Terms and Concepts
Money, the Interest Rate, and Output:

contractionary fiscal policy

contractionary monetary policy

Analysis and Policy

crowding-out effect

expansionary fiscal policy

expansionary monetary policy

goods market
C H A P T E R 12:

interest sensitivity or insensitivity

of planned investment

money market

policy mix

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 22 of 29
 Appendix: The IS-LM Diagram
Money, the Interest Rate, and Output:

• The IS-LM diagram is a

way of depicting
Analysis and Policy

graphically the
determination of
aggregate output
(income) and the interest
C H A P T E R 12:

rate in the goods and

money markets.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 23 of 29
 Appendix: The IS-LM Diagram
Money, the Interest Rate, and Output:

• The IS curve shows a

negative relationship
between the equilibrium
Analysis and Policy

value of Y and r.
• Each point on the curve
represents equilibrium in
the goods market for a
C H A P T E R 12:

given value of the interest

rate.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 24 of 29
 Appendix: The IS-LM Diagram
Money, the Interest Rate, and Output:

• The LM curve shows a

positive relationship
between the equilibrium
Analysis and Policy

value of Y and r.
• Each point on the curve
represents equilibrium in
the money market for a
C H A P T E R 12:

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.
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 25 of 29
 Appendix: The IS-LM Diagram
Money, the Interest Rate, and Output:

• The point at which the

IS and the LM curves
Analysis and Policy

intersect corresponds
to the point at which
the goods market and
the money market are
in equilibrium.
C H A P T E R 12:

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 26 of 29
 Appendix: The IS-LM Diagram
Money, the Interest Rate, and Output:

• An increase in
government spending
Analysis and Policy

shifts the IS curve to

the right.
• This increases the
value of both Y and r.
C H A P T E R 12:

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 27 of 29
 Appendix: The IS-LM Diagram
Money, the Interest Rate, and Output:

• An increase in the money

supply shifts the LM
curve to the right.
Analysis and Policy

• In turn, the value of Y

increases and the
value of r decreases.
C H A P T E R 12:

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 28 of 29
 Appendix: The IS-LM Diagram
Money, the Interest Rate, and Output:

• It is easy to use the IS/LM

diagram to see how there
can be a monetary and
Analysis and Policy

fiscal policy mix that leads

to a particular outcome.
• Here, an increase in the
money supply accompanied
C H A P T E R 12:

by an increase in
government spending leads
to an increase in aggregate
output, with no change in
the interest rate.
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 29 of 29