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Transcript of 12 © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Money,...
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© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Money, the Interest Rate, and Output: Analysis and Policy
Appendix: The IS-LM Diagram
Prepared by: Fernando QuijanoPrepared by: Fernando Quijano and Yvonn Quijano and Yvonn Quijano
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2 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
The Goods Marketand the Money Market
• The goods market is the market in which goods and services are exchanged and in which the equilibrium level of aggregate output is determined.
• The money market is the market in which financial instruments are exchanged and in which the equilibrium level of the interest rate is determined.
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3 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
The Links Between the GoodsMarket and the Money Market
• 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.
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4 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
The Links Between the GoodsMarket and the Money Market
• Planned investment depends on the interest rate and money demand depends on income.
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5 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
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.
• When income falls, the demand for money falls and the interest rate falls.
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6 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Link 2: Planned Investmentand 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 rises, planned investment falls (fewer projects are likely to be undertaken).
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7 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Investment, the Interest Rateand the Goods Market
• 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. r I A E Y
r I A E Y
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8 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Equilibrium in the Money Market (review)
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9 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Money Demand, Aggregate Output (Income), and 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.
Y M rd
Y M rd
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10 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
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).
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11 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
The Crowding-Out Effect
• The crowding-out effect is the tendency for increases in government spending to cause reductions in private investment spending.
G Y M r Id
Y increases less than if r did not increase
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12 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
The Crowding-Out Effect
• The crowding-out effect depends on the sensitivity or insensitivity of planned investment spending to changes in the interest rate.
• Interest sensitivity means that planned investment spending changes a great deal in response to changes in the interest rate.
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13 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
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 simultaneous increase in the demand for money keeps the interest rate from falling as far as it otherwise would.
M r I Y Ms d
r decreases less than if Md did not increase
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14 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Fed Accommodation of an Expansionary Fiscal Policy
• An expansionary fiscal policy (higher government spending or lower taxes) will increase aggregate output (income).
• In turn, higher income will shift the money demand curve to the right, and put upward pressure on the interest rate.
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15 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Fed Accommodation of an Expansionary Fiscal Policy
• If the money supply were unchanged following an increase in the demand for money, the interest rate would rise.
• But if the Fed were to “accommodate” the fiscal expansion, the interest rate would not rise.
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16 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
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 o r T Y
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17 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Contractionary Fiscal Policy
• The decrease in Y is smaller when we take the money market into account.
G M r Id o r T Y
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18 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Contractionary Monetary Policy
• Contractionary monetary policy refers to a decrease in the money supply aimed at decreasing aggregate output (income) (Y).
M r Is Y
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19 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Contractionary Monetary Policy
• When we take into account the money market, the interest rate will increase by less, and the decrease in Y will be smaller.
M r I Y Ms d
Y decreases less than if r did not decrease
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20 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
The Macroeconomic Policy Mix
( Ms)
Forces push the variable in different directions. Without additionalinformation, we cannot specify which way the variable moves.
?:
Variable decreases.:
Variable increases.:
Key:
Y , r ?, I ?, CY ?, r , I , C ?Contractionary
MONETARYPOLICY
( Ms)
Y ?, r , I , C ?Y , r ?, I ?, C Expansionary
Contractionary( G or T)
Expansionary( G or T)
FISCAL POLICY
The Effects of the Macroeconomic Policy Mix
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21 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Other Determinants ofPlanned Investment
• The interest rate
• Expectations of future sales
• Capital utilization rates
• Relative capital and labor costs
The determinants of planned investment are: