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Chapter 17 Microeconomics Intersection Public Policy

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18 views

Chapter 17 Microeconomics Intersection Public Policy

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malik.tia2004
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
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CHAPTER 11

Money, Interest, and Income


CHAPTER HIGHLIGHTS
IS-LM model, is the core of
" The model we introduce in this chapter, the
short-run macroeconomics.
of income and interest rates at
The IS curve describes the combintions
which the goods market is in equilibrium.
the combinations of income and interest rates
" The LM curve describes
in equilibrium.
at which the money market is
aggregate demand.
Together, the IS and LM curves give
spending raise output and interest rates.
government
" Increases in
supply raise output and lower interest rates.
money
" Increases in the
MACROECONOMICS
224

Monctary poicy playN a central role in the determination of


Interest rales are a signilicant determinant of aggregate income
money growth and interest rales, isspending,
and
Rexene, which contrnols
blamed when the cconomy gets into trouble.
rates, and the Federal Reserve seem to
the first
However, the stock of
have no place in the model of
empyefkA
and the
tion developed in Chapter 10. incormonency, iteres
This chapter introduces money and monetary policy and builds
an
deterauta
work of analysis within which to study the interaction of
markets. This new framework leads to an understanding ofthe
explicandit Írate.
goods markets
of asse
est rates and of their role in the business cycle and introduces
an determination
monetary policy affects output. Figure I|-1 shows the interest rate onavenue by which
The interest rate on Treasury bills represents the payment received
lends to the U.S. government. An interest rate of 5 percent means that
by
someone who
bil,Treasury
$5,Someone
lends S100 to the government for I year will receive 5 who
Figure Il-1shows that interest rates are typically, but percent, or in
not always, high just ibefore.
nterest.
recession, drop during the recession, rise during the
and
money growth and output growth. There is a strong, butrecovery. Figure 11-2 shoue
not absolute, link betwean
money growth and output growth.This chapter
est rates to output. explores the link from money to inter.
The model we introduce in this chapter, the
IS-LM model, is the core of short-run
macroeconomics. It maintains the spirit and, indeed, many details of the model of the
previous chapter. The model is broadened, though,by
additional determinant of aggregate demand. In introducing the interest rate as an
fiscal policy were the chief Chapter 10, autonomous spending and
rate as a determinant of determinants of aggregate demand. Now we add the interest
investment and therefore aggregate demand. We then have to
18

16

Percent
per
year
12

970
972 1978 g82
g84
1986 1992
1996
19928
000 2002
2004 2021

FIGURE I1- THE INTEREST RATE


(Source: Federal Reserve ONTREASURY BILLS.
Economic Data |FRED ||))
10

8
GDP growth
6

Percent

-2

Real money growth

1960 1965 1970 1975 1980


1985 1990 1995 2000 2005 2010
peupE 11.2 GDP GROWTH
(QUARTERLY) AND REAL MONEY GROWTH (OVER PREVIOUS YEAR).
Source: Bureau of Economic Analysis and
Federal Reserve Economic Data[FRED I)

ask what determines the interest rate.


That
money market and forces us to study the question extends our model to include the
The Federal Reserve enters the interaction of goods and money markets.
picture
Interest rates and income are jointly through by itsrole in setting the supply of
money.
determined
markets. As in the previous chapter, we maintain the equilibrium in the goods and money
level does not respond when aggregate demand assumption that the price
In Chapter 9, and in actual
shifts.
day-to-day practice, the Federal Reserve focuses on
choosing an interest rate rather than hitting a money supply target. This chapter
control of the money supply as the underpinning of looks at
explains how interest rate targeting and money supply monetary policy. Chapter 12
of the same coin. targeting are really opposite sides
Understanding the money market and interest rates is important for three reasons:
l. Monetary policy works through the money market to
Ihe analysis qualifies the conclusions of Chapter 10.affect output and employment.
Consider Figure 11-3, which
lays out the logical structure of the model. So far, we have
looked at the box labeled
"Goods market." By adding the assets markets, we provide a fuller analysis of the
effect of fiscal policy, and we introduce monetary policy. We shall see, for instance,
a an expansionary fiscal policy generally raises interest
rates,
CApansionary impact. Indeed, under certain conditions, the thereby
increase
dampening
in interest
Tales may be sufficient to offset fully the
expansionary effects of fiscal policy.
MACROECONOMICS
226

11-1 What More Do We Know?


Seemingly Difficult Material Alert
Let us be blunt. This is the chapter students find most dilicult lo master
We study two markets - the goods market and the money morkot--
ond
age through two economic voriables-interest rates and income. Many sludontstheit lin
hard to link the formal two-morket-twovariable model with verbal discussion find
economic operation of each market. So betore diving into the substance of theo
of the
we'llbriefly explain here how things willconnect up by the time we're dono.
In the previous chapter we looked at a simple model of the goods market and
chopte,
found the value of GDP at which equilibrium output equaled aggregale demand W
hodone market-goods -cleared by one variable-GDP (Y). The frst thing we do in
this chapter is introduce the interest rate into the goods market (via investment demand),
leaving us with one market ond wo variables, GDP and the interest rate (i) We .:ll
eventually callthe goods market equation the 1S curve.
Next we introduce the money market, where equilibrium is determined when k
demand for money equals the supply of money. The demand for money depends on
income and interest rotes. The supply of money is set by the central bank (the Federal
Reserve in the United Stotes). Solving for equilibrium in the money market again gives
US one market and two vorigbles, GDP ond the interest rate. We will eventually call the
money market equation the M curve.
Finally, we put the goods and money markets together, giing us two markets (goods
and money) and two variables (GDP and the interest rate). The ISM model finds the values
of GDP and the interest rate, which simultaneously clear the goods and money markets.
As we put all this together, be certain to keep a mental marker on whether we are
talking about just the goods market, just the money market, or the linkage of the two.
(Use differentcolor highlighters if it helps.) If you can do this, you should find the chopter
not too difficultater all,

3. Interest rate changes have an important side effect. The composition of aggregate
demand between investment and consumption spendingdepends on the interest
rate. Higher interest rates dampen aggregate demand mainly by reducing invest
ment. Thus, an expansionary fiscal policy tends to raise consumption through tne
multiplier but tends to reduce investment because it increases interest rates. bedu
the rate of investment affects the growth of the economy, this side effect of fiSCa
expansion is a sensitive and important issue in policymaking.

OUTLINE OF THE CHAPTER

We use Figure II-3 once more to lay out the structure of this chapter. We start in
Section |1-1 with a discussion of the link between interest rates and aggregate demand.
CHAPTER l"MONEY, INIEREST, AND INCOME 227

Income

Assets morkes
Goods market
Moneyoret Bond morket
Aggregato dernond
Denond Demond Qutput
Suppy Supply

Interest rates

Monetary policy Fiscal policy

sGURE I13 THE STRUCTURE OF THE IS-M MODEL


The IS-LM model empbasizes the interaction between the goods and assets markets.
Sding. interest rates, and income are determined jointly by equilibrium in the goods
and ases markets.

We use the model of Chapter 10 directly, augmented to include the interest rate as a
determinant of aggregate demand. We derive a key relationship-the IS curve-that
markets
shows combinations of interest rates and levels of income at which the goods
clear. In Section 11-2 we turm to the assets markets, particularly the money market. We
there are
show that the demand for money depends on interest rates and income and that
the money
combinations of interest rates and income levels-the LM curve-at which
the joint deter
market clears. In Section 11-3 we combine the two schedules to study
mination of interest rates and income. In Section l1-4, we formallyderive the aggregate
demand schedule. In Section 11-5, which is optional, we give a formal algebraic presen
tation of the full /S-LM model.
introduced,
The IS-LM model continues to be used today, 75 years after it was
the effects of
because it provides a simple and appropriate framework for analyzingrates.? To keep the
monetary and fiscal policy on the demand for output and on interest model for
applications of the
chapter from becoming too long, we reserve policy
Chapter 12.

the relationships investment () equals


Ihe terms /S and LM are shorthand representations, respectively, of
equals money supply (M)the money
Saving (S-the goods market equilibrium--and money demand (L)
model is J. R. Hicks, "Mr. Keynes and the Clas
market equilibrium. The classic article that introduced this
SICs: ASuggested Interpretation," Econometrica, April 1937, pp. 147-59. Edward
the /S-LM model, see Bennett T. McCallum and
Tor amodern perspective on the usefulness of Analysis," Journal of
Policy and Business Cycle
Nelson, "AnOptimizing /S-LM Specification for Monetary Does the IS/LM Model Fit Postwar
Jordí Gali, "How Well
MOney, Credit, and Banking,August 1999. See also
U.S. Data?"Quarterly Journal of Economics, May 1992.
228 MACROECONOMIC S

11-1
THE GO0DS MARKET AND THE SCURVE
In this seion we derive a goods market equilibrimshedule, the IS
curve (or schedule) shows combinations of s ofcurve. The IS,
interest rates and levels
that planned spending equals income. The Scurveis derived in two
explan why investment depcnds on interest rates. Second, we insert the steps. Firt utput sah
demand function in the aggregate demand identityjust as we did with
tronfunction inthe last chapter--and find the combinations of the incorne and irvcoemsstrnufei
that keep the goods market inequilibrium. interest tales
THE INVESTMENT DEMAND SCHEDULE
So far, investment spending (/) has been treated as entirely exogenous--some nurt
like SI.000 billion, determined altogether outside the model of income determina
Now, as we make our macromodel more complete by introducing interest rates as a n
of the model, investment spending, too, becomes endogenous. The desired or plannod
rateof investment is lower the higher the interest rate.
Asimple argument shows why. Investment is spending on additions to the firm's
capital, such as machines or buildings. Typically, firms borrow topurchase investment
goods. The higher the interest rate for such borrowing, the lower the profits that firms
can expect to make by borrowing to buy new machines or buildings, and therefore the
less they will be willing to borrow and invest. Conversely, firms will want to borrow and
invest more when interest rates are lower.

INVESTMENT AND THE INTEREST RATE

We specify an investment spending function of the form


|=1- bi b>0 ()
where iis the rate of interest and the coefficientb measures the responsiveness ot inves
ment spending to the interest rate. Inow denotes autonomous investment spend1ng, thal
I5, investment spending that is independent of both income and the rate of interesl.

"Here and in other places in the book, we specify linear


(straight-line)
use the linear form to simplify both the algehra and thc diagrams. versions assumption
The linearity of behavioral tunetos
is not misleading
as long as we confine ourselves to talking
about small changes in the economy.
"In Chap. J0, investment spending was defined as autonomous with respect to income, Now that the interest
rate appears in the model, we have to exlend the
definition
interest rate and income. To conserve notation, we continueof"autonomous"
to use /to denotetoautonomous
mean independent o but we
iinvestment,
recognize that the definition has broadened. In fact, investment responds positively when income increases,
for reasons discussed in Chap. 15. Here, we onit the responsiveness of investment to income as a
simplification.
CHAPTE RItONEY NTEREST. ANOINKONE 229

ietere

Planned investment spending

FIGURE I|-4 THE INVESTMENT SCHEDULE.


investment spending at each rate of
The intestment schedule sbows the planned level of
1nleresI.

higher is planned investment. If b


Equation (|) states that the lower the interest rate, the
the interest rate generates a large drop in
is large, then a relatively small increase in
investment spending.
equation (| ), shows for each level of the
Figure I|-4, the investment schedule of is nega
to spend on investment. The schedule
interest rate the amount that firms plan the
a reduction in the interest rate increases
tively sloped to reflect the assumption that therefore leads to a larger rate of
profitability of additions to the capital stock and
planned investment spending.
investment schedule is determined by the slope-the coefti
The position of the It
of autonomous investment spending, 1.
Cient bin cquation ()-and by the level rates will
interest rate, a small decline in interest
Investment is highly responsive to the schedule is almost flat. Conversely, if
increase in investment, so the
lead to a large nearly vertical.
rates, the schedule will be more
investment responds little to interest

invesment is mea
of inteiest rale, i. Il
denend o) the units of eUsuleDeHt
The units of measurement of b "percetper year is implicitin
interest rate is written as numbers like 5 or 10- so instead as
Sured in billions and the same interest rate were written
number-then b might be a Dunber like I0, IT he
the interest rate like 1,000.
value of b would be a DUmber
O.05 or 0.10, then the cquivalent
MACROECONOMICS
230

invesment spending, 7, shift the


ineease in autonomous
investment schedule
Changesin meausthat at each level ofthe interest rate. frms planto invest
rale, This would be shown by a righvward shift ofthe investnment schedule.

dem
Aaa
S CUPUr
RATE AND AGGREGATE DEMAND: THE
THEINTEREST
Chapter 10 to reflect
now modity thc aggrgate demand function of still he new plarnes,
We schedule. Aggregate demand consists of the
investnent spending
sumptio, investment,
government spending on goods and services,
rate. We bave
and for cn demand
nel expns
onlv nov ivestment spending depends on the interest

AD =C+1+G + NX
G+ NX
= |C+ cTR + c(| - )Y] + (l- bi) +
=A+ c| - )Y - bi

where
cTR +*+ G+ NX (3)
aggregate demand
From equation (2) we see that an increase in the interest rate reduces
investment spendine
for a given level of income because a higher interest rate reduces
the level of
Note that A, which is the part of aggregate demand unaffected by eithernamely. As
spending,
income or the interest rate, does include part of investment
noted earlier, Iis the autonomous component of investment spending, which is indepen:
dent of the interest rate (and income).
10 to
At any given level of the interest rate, we can still proceed as in Chapter
determine the equilibrium level of income and output. As the interest rate changes, how
ever, the equilibrium level of income changes. We derive the IS curve using Figure l1-5.
For a given level of the interest rate, say, i,, the last term of equation (2) is a con
stant (bi,), and we can, in Figure 11-5a, draw the aggregate demand function of
Chapter 10, this time with an intercept, A - bi,. The equilibrium level of income
obtained in the usual manner is Y, at point E,. Since that equilibrium level of income
was derived for a given level of the interest rate (i,), we plot that pair (i,, Y,) in the bot
tom panelas point E,. This gives us one point, E,, on the IS curve-that is, one combi
nation of interest rate and income that clears the goods market.
when the interest
Consider next alower interest rate, i,. Investment spending is higher demand
rate falls. In terms of Figure I1-5a, that implies an upward shift of the aggregate the
schedule. The curve shifts upward because the intercept, A - bi, has increased, Given
income
increase in aggregate demand, the equilibrium shiftsto point E,, with an associated
level Y,. At point E, in panel (b), we record the fact that interest rate i, impliesthe equilib-
rium level of income Y,equilibrium in the sense that the goods market is in
cquilibrium
(or that the goods market clears). Point E, is another point on thelS curve. and
We can apply the same procedure to all conceivable levels of the interest rate
thereby generate all the points that make up the IS curve. They have in common the
property that they represent combinations of interest rates and income (output) at which
AD = }

A+c(l -)) -bi,


E,
dermand
hggregate

A+c(l- )- bi,

bi,

Y
Y
Income, output
(a)

E
rate
Interest

income, ouot

(b
GRE5 DERVATON OF THE SCURVE
a dpgies eircc
11 a particular interest rate euilibrium in Dar
hS
de rease in the interest rate ruises aggrezate demard
eRa'u e relatoso:p ueen interst rates and :nmE

231
MACROECONOMICS

is called thc goods


the goods market clears, Tbat is why the IS curve arket
schedule.
Figure l1-5 shows that the /S curve
lggrgte demand associated with a
is negutively sloped, rellecting
ihe
rcduction in theinterest rate. We can also)o
ciqnucrilCbaerum in
IS curve by using the goods arket
cquilibrium condition, that
income cqualsderive the
spending, or p lan ed
Y= AD =A t | - DY- bi
(4

which can be simplified to

Y= a,A - bi) (5)


where a, is the multiplier from Chapter 10. Note from equation (5)that higher inter-
est rate implies alower level of equilibrium income for a given A, as Figure |1-5 showS,
straightforward and may even be
The construction of the IS curve is quite decep-
economics of the /S cums
tively simple. We can gain further understanding of the
asking and answering the following questions:
What determines the slope of the IS curve?
What determines the position of the IS curve, given its slope, and what causes the
curve to shift?

THE SLOPE OF THE IS CURVE

We have already noted that the /S curve is negatively sloped because a higher level of
the interest rate reduces investment spending, thereby reducing aggregate demand and
thus the equilibrium level of income. The steepness of the curve depends on how
sensitive investment spending is to changes in the interest rate and also depends on the
multiplier, aç, in equation (5).
Suppose that investment spending isvery sensitive to the interest rate, and so bin
equation (5) is large. Then, in terms of Figure 11-5, a given change in the interest rate
produces a large change inaggregate demand, and thus shifts the aggregate demand
curve in Figure 11-5a up by a large amount. A large shift in the aggregate demand
schedule produces acorrespondingly large change in the equilibrium level of income. l
a given change in the interest rate produces a large change in income, the 1S curVe 1s
very flat. This is the case if investment is very sensitive to the interest rate,
that is,
large. Correspondingly, if bis small and investment spending is not very
interest rate, the IS curve is relatively steep. sensitive0U
The Role of the
Multiplier
Consider next the effects of the multiplier, a, on the
Figure 1|-6 shows aggregate demand steepness of the i
curves to different multipliers.
black aggregatecorresponding
The coefficient c on the solid
corresponding coefficient c' on the dashed black demand curves is smaller than the
aggreg ate demand curveo
Aggregate demand

Interest rate
-b
Ai
AD

Y,

Income,
output
ut, Y
Y (a)

Y2

IS AD= Y
A A
A +cU- A
+ + +
c(1
c(l cCU
Y -)Y- -
)Y- )Y )Y- -
Y
bl,
bi, bi, - bi,
234 MACROECONOMICS

The multiplier is accordingly larger on the dashed aggregate demand


levels of income. Y, and Y, correspond to the interest rate , in panel (b),
Agiven reduction inthe interest rate,
to i,, raises the
curves. \he inin
demand curves by the same vertical
distance, as shown in panel
(a). interCepl of thc
change in income is very different.
On the dashed Curve, incorne rises However. he
rises only to Y, on the solid line. The change in
equilibrium ,1o Y, inpl
income
given change in the interest rate is accordingly larger as
steeper. that is, the larger the multiplier, the greater the
the
rise
aggregate
in income. rAsespondiwhncuregrevaejinin
Cordemand
panel (b). the larger the multiplier, the flatter the IS curve.
we see
multiplier,the larger the change in income produced by a given
Equivalently. th irom
change in the e larger he
We have thus seen that the smaller the sensitivitv of
investment intnegrestto ras.the.
spendi
interest rate and the smaller the multiplier, the steeper the IS curve.
sion is confimed using equation (5). We can turn equation (5); around This
interest rate as a function of the level of income: to
expreconcu-
ss the
i=A_ Y
a,b (5a)
Thus, for a given change in Y, the associated change in i will be larger in size. as
bis
Smaller and as a, is smaller.
Given that the slope of the IS curve depends on the multiplier, fiscal policy eox
affect that slope. The multiplier. aç. is affected by the tax rate: An increase in the tay
rate reduces the multiplier. Accordingly, the higher the tax rate, the steeper the IS curye 5

THE POSITION OF THE IS CURVE

Figure 11-7 shows two different /S curves, the lighter one of which lies to the right and
above the darker /S curve. What might cause the IS curve to be at /S' rather than at
IS?
The answer is an increase in the level of autonomous
spending.
In Figure l1-7awe showan initial aggregate demand curve
drawn for a level of
autonomous spending Aand for an interest rate i,. Corresponding to the initial agge
gate demand curve is the point E, on the IS curve in Figure
11-7b. Now, at the same
interest rate, let the level of autonomous spending increase to A'.
The increase in auton
omous spending increases the equilibrium level of income at the interest rate l, The
point E, in panel (b) is thus a point on the new goods market equilibrium
SnCe E, Was an artbitrary point on the initial IS curve, we can perform theschedule, lD.
all lévelS of the interest rateand thereby generate the exercise 10
in autonomous new curve. IS'. Thus, an iniea
spending shifs the IS curve out to the right.
By how much does the
in autonomous spending cancurve shift? Thepanel result of the change
be seen from change
(a) into income as a multiplier
be just the timesthe
change in autonomous spending. This by a
distance equal to the multiplier times themeans thatintheautonomous
change shifted horizontally
IS curve is spending, as in panel(b.
In the problem set at
the end of this chapter we automat
stabilizers in Chap. 10. ask vou to relate this fact to the discussion of
AD

AD

demand
Agyregte
A+c0- )Y- b,

A+ c(| - )Y- bi,

AY= aAA

Y
Income, output
(a)

Interest
rate

AY= aA
IS

Y, Y

Income, output
(b)
FHGURE 11-7 A
SHIFT IN THE IS CURVE CAUSED BY ACHANGE IN AUTONOMOUS SPENDING.
An increase in autonomous spending increases aggregate demand and increases the
income level at a given interest rate. This is represented by a rigbtward shift of the IS curve.

235
MACROECONOMICS
236

cquation (3), ic
The levcl of autonomous spend1ng, lrom

purchases or
Amnnlh, an innasein gOveMment Iranster payments shifts
out to the ngh. with the extent of the shift depending on the size
shifte
Amton intranster paymentsor n govemiICht purchases the IS
curve to the
Her are the major points about the IS curve:
" The Scurve is the schedule of combinations of the interest rate and
such that the goods market is in cquilibrium.
The /S curve is negatively sloped because an increase in the interest
level of incOme
planned investment spending and|therefore reduces aggregate demand rate reduce
thus
the equilibrium level of income.
The smaller the multiplier and the less sensitive investment
spending is to
reduCing
the interest rate, the steeper the IS curve.
" The /S curve is shifted by changes inautonomous spending. An increase in o
in changeS
mous spending, including an increase in government purchases, shifts the /C.
out to the right.
Now we turn to the money market.

11-2
THEMONEY MARKET AND THE LM CURVE
In this section we derive a money market
equilibrium schedule, the LM curve. The LM
curve (or schedule) shows combinations of interest rates and
that money demand equals money supply. The LM curve is levels inoutput such
of
First, we explain why money demand depends on derived two steps.
interest rates and income, emphas1z
ing that because people care about the
purchasing power of money, the demand tor
money is a theory of real rather than nominal demand.
demand with money supply-set by the central Second, we equate mone)
income and interest rates that keep the money bank-and find the combinations o
market in equilibrium.
THE DEMAND POR MONEY
We turn now to the money
market and initially on the demand for real
balances.' The demand for money is ademand for conccntrate
realnOneyvbalances because peoplk
"The demand for money is
demand for money only briefly.examined in depth in Chap. l6; here we prescnt the arguments underlyingthe
CHAPIER ||"MONEY, INIEREST, ANDINCOMI 237

11-2 What More DoWe Know?


Real and Nominal Money Demand
At this stage we have to reintorce the crucial distinclion betweon real and nominal vari
les The nominal demand tor money is the individual's domand for a given number of
Jalors. Similarly, the nominal demand for bonds is the demand for a given number of
dollors' worth of bonds. The real demand for money is the demand for money expressed
in terms of the number of units of goods that money will buy: lh is equal to the nominal
demand for money divided by the price level. If the nominal demand for money is $100
and the price level is $2 par good--meaning that the representative basket of goods cost
$2-the real demand for money is 50 goods. If the price level later doubles to $4 per
good and the demand for nominal money likewise doubles to $200, the real demand for
money is unchanged at 50 goods.
Real money balances-real balances, for short-are the quantily of nominal
money divided by the price level. The real demand for money is called the demand for
real balances.

holdmoney for what it willbuy. The higher the price level, the more nominal balances
a person has to hold to be able to purchase a given quantity of goods. If the price level
doubles, an individual has to hold twice as many nominal balances in order to be able to
buy the same amount of goods.
The demand for realbalances depends on the level of real income and the interest
ate. It depends on the levelof real income because individuals hold money to pay for
their purchases, which, in turm, depend on income. The demand for money depends also
on the cost of holding money. The cost of holding money is the interest that is forgone
by holding money rather than other assets. The higher the interest rate, the more costly
it is to hold money and, accordingly, the less cash willbe held at each level of income.8
Individuals can economize on their holdings of cash when the interest rate rises by
being more careful in managing their money and by making transfers from money to
bonds whenever their money holdings become large. If the interest rate is I percent,
there is very little benefit from holding bonds rather than money. However, when the
interest rate is 10 percent, it is worth some effort not to hold more money than is needed
to finance day-to-day transactions.
On these simple grounds, then, the demand for real balances increases with the
level of real inconme and decreases with the interest rate. The demand for real balances,
which we denote as L, is accordingly expressed as
L= kY - hi k, h>0 (6)

but at a lower rate than bonds. Several


Some types of money, including most bank deposits, earn interest,
currency-earn no interest: so. overall. money earns less interest
Sizable parts of money holding-including
than other assets. Thus, there is an interest cost to holding money.
LM
i E
Interest
rate
rate
Interest

L,= kY, -bi


E

L, = kY, - bi

M/P L
Y,
Real balances
(a) Income, output
(b)
FIGURE 19 DERIVATION OF THE LM CURVE.
Panel (u) shows tbe money market. Tbe supply of real balances is the vertical line
levels of income (Y, and Y, ). M/P. L, and L, represent money demand at dileret
CHAPTER I|"MO NEY, INIEPESI, ANDINCOME 241

sMccperthe LA euve will be This point cn be cstablished by experinenting with


Figure l|9 hcn alo be contimed by Cxamininy equation(u), where a given change
le. . has alarger ele on the interest rate, 1, the latyer is kand the smaller
demand tor money is relatively insensitive to the interest rate and thus h is
ow 0 zen, the ZM curve is nearly vertical. fthe demand for money is very sensitive
othe inteest rate and thus h is large, the LM curve is close to horizontal. Sn that cae, a
mallchangeinthe interest rate must be accompanied by alarge change in the level of
incme in order to maintain money market cquilibrium.

THEPOSITION OF THE LM CURVE

The real moncy supply is held constant along the LM curve. It follows that a change
in the real money supply will shiftthe LM curve. In Figure I |-10 we show theeffect
of an increase in the real money supply. Panel (a) shows the demand for real money
balances for a level of income Y,. With the initial real money supply, M/P, the equi
librium is at point E,, with the interest rate i,. The corresponding point on the LM
schedule is E,.
Nowthe real money supply increases toM'/ P, which we represent by a right
ward shiftof the money supply schedule. Torestore money marketequilibrium at the
income level Y,, the interest rate has to decline to i,. The new equilibrium is, there
fore, at point E,. This implies that in Figure l1-10b, the LM schedule shifts to the
right and down toLM'. Ateach level of income the equilibrium interest rate has to be
lower to induce people to hold the larger real quantity of money. Alternatively, at each
level of the interest rate the level of income has to be higher to raise the transactions
demand for money and thereby absorb the higher real money supply. These points
can be noted, too, from inspection of the money market equilibrium condition in
equation (7).

RECAP

The following are the major points about the LM curve:


" The LM curve is the schedule of combinations of interest rates and levels of income
such that the money market is in equilibrium.
The LM curve is positively sloped. Given the fixed money supply, an increase in the
level of income, which increases the quantity of money demanded, has to be accom
panied by an increase in the interest rate. This reduces the quantity of money de
manded and thereby maintains money market equilibrium.
The LM curve is steeper when the demand for money responds strongly to income
and weakly to interest rates.
Ihe LM curve is shifted by changes in the money supply. An increase in the money
supply shifts the LM curve to the right.
We are now ready to discuss the joint equilibrium of the goods and assets markets.
determined.
udt iS tO say, we can now discuss how output and interest rates are
M/P M/P
Real balances
(a)
RIGHI
MONEY SHIFTS THE LM CURVE TO THE
INCREASE IN THE SUPPLY OF
FIGURE 11-10 AN

onludisbr The
Interest rate
fiscalpoli
derermeínqeuilibriur income is
Figur
FHgurma
e r
1ke
-]
EQUIL1IBR-3
egui
derermine hI5
t a
and
CHAPTER 11"MONEY, INTEREST, AND INCOME 243

11-3
EQUILIBRIUM IN THE GOODS AND MONEY MARKETS
TheISand LM schedules summarize the conditions that have to be satisfied in order for
thegoods and money markets, respectively, to be in equilibrium. The task now is to
determine howthese markets are brought into simultaneous equilibrium. For simultane-
ousequilibrium, interest rates and income levels have to be such that both the goods
market and the money market are in equilibrium. This condition is satisfied at point Ein
Figure1l-11. The equilibrium interest rate is therefore i, and the equilibrium level of
income is Y giventhe exogenous variables, in particular, the real money supply and
fiscal policy. 10 At point E, both the goods market and the money market are in
equilibrium.
Eioure 11-ll summarizes our analysis: The interest rate and the level of output are
determined by the interaction of the money (LM) and goods (/S) markets.

LM

Interest
rate
E

IS

Income, output

FIGURE 11-1l GOODS AND MONEY MARKET EQUIUBRIUM.


such that the public bolds the existing money
pOMT E, interest rates and income leels are
Stock and planned spending equals output.
studied.
values are not determined within the svstem being
"n general,. variables are those whose
exogenous
MACROECONOMICS

review our assumptions and


It is worth stepping back now to
the price level is
the meaning
equilibrium at E. The major assumption is that
output is demandedat constant and
of lhe
are willing to supply whatever
amount of hat
that price Iirms
we assumethat the level of
output Y,in Figure 11-1lwill be
willingly uppliedlevelby. firns
this assumption is one that is ThuNS,
at the price level P. We repeat that
the development of the analysis; it
corresponds to the temporarily
assumption of a needed for
lat,
aggregate supply curve.
shor-Tun
CHANGES IN THE EQUILIBRIUM LEVELS OF INCOME AND THE INTEREST RATE

change when
The equilibrium levels of income and the interest rate either
the IS or
11-12, for example, shows the effects of an in the
LM curve shifts. Figure
equilibrium levels of income
increase
and the he rale
of autonomous investment on the
interest
Such an increase raises autonomous spending, A, and therefore shifts the IS curve torate. the
right. That results in a rise in the level of income and an increase in the
point E'. interest
rate at
Recall that an increase in autonomous investment spending, Al, shifts the
IS
to the right by the amount aAl, as we show in Figure 11-12. In Chapter 10, wherecurve

LM

rate
Interest

IS'

IS

Yo
Income, output
FIGURE l1-12 AN INCREASEIN AUTONOMOUS SPENDING SHIFTS THE IS CURVE TO THERIGH.
Theeguilibrium interest rate and
level of income both rise.
CHAPTER||"MONEY, INTEREST, AND INCOME 245

dealt only with the g00ds market. we would have argucd that a, Awouldbe the change
in the level of income resulting from the change of S/in autonomous spending. But it
ean be seen in Figure |1-12 that the change in income here is only AY,, which is clearly
less than the shift in the 7S curve, a, AI.
What explains the fact that the increase in income is smaller than the increase in
autonomous spending. l times the simple multiplier. a? Diagrammatically. it isclear
thal the explanation is the slope of the LM curve. If the LM curve were horizontal. there
NOuldbe no difference between the extent of the horizontal shift of the IS curve and the
change in income. If the LM curve were horizontal. the interest rate would not change
when the /S curve shifts.
But what is the economics of what is happening? The increase in autonomous
snending does tend toincrease the level of income. But an increase in income increases
the demand for money. With the supply of money fixed, the interest rate has to rise to
ensure that the demand for money stays equal to the fixed supply. When the interest rate
rises. investment spending is reduced because investment is negatively related to the
interest rate. Accordingly, the equilibrium change in income is less than the horizontal
shift of the IS curve, a AI.
We have now provided an example of the use of the IS-LM apparatus. That appa
ratus is very helpful for studying the effects of monetary and fiscal policy on income
and the interest rate, and we use it to do so in Chapter 12. Toanticipate what is coming.
you might want to experiment with how equilibrium income and interest rates change
when expansionary fiscal policy moves the IS curve to the right or expansionary mone
tary policy moves the LM curve to the right.

11-4
DERIVING THEAGGREGATE DEMAND SCHEDULE
apparatus. Here we
Inearlier chapters we used the aggregate demand-aggregate supply
schedule mapsout the
derive the aggregate demand schedule. The aggregate demand
IS-LM equilibrium holding autonomous spending and thelearningnominal money supply
to use the IS-LM
constant and allowing prices to vary. In other words, in
aggregate demand sched
model, you've already learned everything about deriving the an LM curve
money supply,
ule. Put simply, a higher price level means a lower real
shifted to the left, and lower aggregate demand.
Figure 11-13 shows the
Suppose the price level in the economy is P,. Panel (a) ofdetermines the position
IS-LM equilibrium. Note that the real money supply, which curves gives the level of
LM,
of the LM, curve, is M/ P,. The intersection of the 7S and
so marked in the lower panel (b).
aggregate demand corresponding to price P, and is curve LM, shows the LM curve
The
Suppose, instead, that the price is higher, say P,.
on the real money supply M/ P,. LM, is to the left of LM, since M/P,s M/ P,.
based aggregate demand curve. Repeat this
Point E, shows the corresponding point on the points to derive the aggregate
operation for avariety of price levels, and connect the
demand schedule.
6

FIGURE Price level


Interest rate
11-13 P
P
MACROECONOMICS
DERIVATION

OF
THE
AGGREGATE
Income,
output Yy
E Income,
output
(b)
(a)
DEMAND
E,

SCHEDULE. AD LM,

LM,
CHAPTERI|"MONEY, INTEREST, ANDINCOME 247

"OPTIONALo

11-5
AFORMAL TREATMENTOF THE IS-LM MODEL
expositionsofar has been verbal and graphical. We now round off the analysis with
Qur treatment of the IS-LM model.
moreformal, algebraic,
a

EQUILIBRIUM INCOME AND THE INTEREST RATE

of the IS and LM schedules determines equilibrium income and the


The intersection
equilibrium interest rate. We now derive expressions for these equilibrium values by
ing the equations of the IS and LM schedules. Recall from earlier in the chapter that
the goods market equilibrium equation is
ISschedule: Y= .A - bi) (5)

and that the equation for the money market equilibrium is

LM schedule: i=
-) (7a)

The intersection of the IS and LM schedules in the diagrams corresponds to a situ


ation in which both the 1S and the LM equations hold: The same interest rate and income
levels ensure equilibrium in both the goods and the money market. In terms of the equa
tions. that means we can substitute the interest rate from the LM equation (7a) into the
IS equation (5):

Collecting terms and solving for the equilibrium level of income, we obtain

haG A +
baç M
(8)
Y=
h + kbaç h + kbaG

or equivalently

Y=y + b M (8a)

Where y = a/l+ ka b/h),"Equation (8)shows that the equilibrium level of income


uepends on two exogenous variables: (1) autonomous spending (A), including
dutonomous consumption and investment (C and I) and fiscal policy parameters

whichever one you find


Cqua0ons (8)and (8a)are two different wavs to wTite the same formula. Work with
more convenient in a particular situation.
MACROECONOMICS

(G, TR), nd (2) the rcal moncy stock(M/P). Equilihbriumincome is


the level of autonomous spendin:, A, and the higher the stock of real higher
Fquation (8) is the aggregate demand schedule. It
sunmaribalzesances.
relation, relating ) and for given levels ofA nd M. Since Pis in the
the aggregate demandcurve slopes downward.
The cquilibrium rate of interest, i, is oblaincd by substituting the
income level, ,, from cquation(8) into the cquation of the LMIschedule

ko; M
denomnASA
A
h + kba; h + kha; P

or cquivalently
J M
ha, P
(9ay
Equation (9) shows that the equilibrium interest rate depends,on the
fiscal policy captured in the multiplier and the term Aand on the
higher real money stock implies a lower equilibrium interest rate.
real pararneters
money stock. A
For policy questions we are interested in the precise relation between
fiscal policy or changes in the real money stock and the resulting changessin chaanges
in
income. Monctary and fiscal policy multipliers provide the relevant informatios equilibrium
THE FISCAL POLICY MULTIPLIER

The fiscal policy multiplier shows how much an increase in government sDendine
changes the equilibrium level of income, holding the real money supply constant
Examine equation (8) and consider the effect of an increase in government spending on
income. The increase in government spending, AG, is a change in autonomous spend.
ing, so AA = AG. The effect of the change in Gis given by

y=
haç (10)
h t kbag
The expression yis the fiscalor government spending multiplier once interest rat
adjustment is taken into account. Consider how this multiplier, y,differs from the sim
pler expression a, that applied under constant interest rates. Inspection showsthat yis
less than ca, since 1/(I + ka b/h) is less than 1. This represents the dampening ene
of increased interest rates associated with a fiscal expansion in the S-LM model.
We note that the expression in equation (10) is almost zero if his verysmalland
that it is equal to ,, ifh approaches infinity. This corresponds,, respectively, to vertical
and horizontal LM schedules. Similarly, a large value of either b or kserves to reduce
the effect of government spending on income. Why? Ahigh value of kimplies alarge
increase in money demand as income rises and hence a large increase in interest rates
required to maintain money market equilibrium. In combination with a high b, this
implies a large reduction in private aggregate demand.
CHAPTER 1l-MONEY INTEREST, ANDCNE 249

MONETARY POLICY MULTIPLIER


THE
The monelary policy multiplier shows how much an increase in the real money sup-
plyincreases the equilibrium level of income, keeping fiscal policy unchanged.
Using equation(8) to examine the effects of an increase in the real money supply n
income., we have

AY
A(M/P) ht kbaG
Thesmaller hand k and the larger b and a,, the more expansionary the effect of an
increaseinreal balances on the equilibriumlevel of income. Large b and a,, correspond
to avery flat /S schedule

SUMMARY
, The IS-LM model presented in this chapter is the basic model of aggregate dernand
that incorporates the money market as well as the goods market. It lays particular
stress on the channels through which monetary and fiscal polícy affect theeconormy.
The /S curve showscombinations of interest rates and levels of income such that the
2.
goods market is in equilibrium. Increases in the interest rate reduce aggregate de
of
mand by reducing investment spending. Thus, at higher interest rates. the level
IS curve slopes
income at which the goods market is in equilibrium is lower: The
downward.
dernandfor real balances
3. The demand for money is a demand for real balances. The
the cost of holding
increases with income and decreases with the interest rate,
supply of real balances,
money rather than other assets. With an exogenously fixed
is upward-sloping.
the LM curve, representing money market equilibrium,
determined by simultaneous equilib
4. The interest rate and levelof output are jointly
at the point of intersection of the
rium of the goods and money markets. This occurs
IS and LM curves.
first by affecting the interest rate and then by
5. Monetary policy affects the economy money supply reduces the interest
affecting aggregate demand. An increase in the demand, and thus increases equi
aggregate
rate, increases investment spending and
librium output.
determine the aggregate demand schedule.
6. The IS and LM curves together monetary
affect the economy through the
7. Changes in monetary and fiscal policy
and fiscal policy multipliers.

KEY TERMS
monetary policy multiplier
aggregate demand goods market equilibrium
money market equilibrium
schedule schedule
schedule
central bank IS curve real money balances
demand for real balances IS-LM model

fiscal policy multiplier LM curve

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