Chapter 17 Microeconomics Intersection Public Policy
Chapter 17 Microeconomics Intersection Public Policy
16
Percent
per
year
12
970
972 1978 g82
g84
1986 1992
1996
19928
000 2002
2004 2021
8
GDP growth
6
Percent
-2
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.
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
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.
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.
ietere
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
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,
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
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
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,
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
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)
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
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
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
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
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
LM schedule: i=
-) (7a)
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)
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
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