11 MONEY, INTEREST, AND

INCOME

FOCUS OF THE CHAPTER

• This chapter introduces the IS-LM modelthe heart of short-run macroeconomic
theory.

• The simple model of Chapter 10 is extended to include the interaction of goods

and money markets, which, together, uniquely determine both the interest rate
and the position of the AD curve.

• Both investment and the interest rate are now endogenous variables: investment
is a function of the interest rate, which is determined by the equilibrium
conditions for goods and money markets.

SECTION SUMMARIES

1. The Goods Market and the IS Curve

This section derives the IS curve. The IS curve shows all of the combinations of
income and the interest rate for which the goods market is in equilibrium (Y = AD).
This equilibrium turns out to be a function of the interest rate because AD is now a
function of the interest rate: We develop an investment function, which shows that
the level of investment falls when interest rates increase.

Our investment function is written as follows:

where i is the real interest rate, is a constant which represents autonomous

investment, and b is a coefficient which measures the responsiveness of
investment spending to changes in the interest rate.
If we imagine that firms borrow the money that they use for investment, it is easy to
see why their investment decisions should be affected by the interest rate: higher
real interest rates mean more expensive loans, and therefore lower returns on

108
109 CHAPTER 11

investment opportunities. When we incorporate this investment function into our AD

schedule, we find that AD is now a function of the interest rate as well:

AD=( C̄ +cY ) +( Ī −bi )+Ḡ

or, allowing both income taxes and transfers,

AD=(C̄ +c [ ( 1−t)Y +TR ])+( Ī −bi )+Ḡ

= Ā +c (1−t )Y −bi

where Ā=C̄+ Ī + Ḡ+ c { T̄ R̄¿ . Ā , as before, represents autonomous spending.

As before, we can find the level of output for which the goods market is in
equilibrium by imposing the requirement Y =AD . The only difference now is that
there will be one of these equilibria for each value of i, the real interest rate. We
derive the IS curve by allowing the interest rate to vary, and plotting the
combinations of i and Y for which the goods market is in equilibrium. This is done
graphically in Figure 10–1. It is also done algebraically, below:

Y = Ā +c (1−t )Y −bi
Y −c(1−t )Y = Ā−bi
(1−c(1−t))Y = Ā−bi

or,
1
Y= ( Ā−bi )
1−c(1−t) ,

1
which tells us that the IS curve is negatively sloped. Notice that the term 1−c (1−t ) is
the multiplier (G) that we found in the last chapter. An increase in this
multipliercaused either by an increase in the mpc or a decrease in the tax
ratemakes the IS curve flatter.*

Just as in Chapter 10 a change in autonomous spending changed the equilibrium

level of output, a change in autonomous spending here shifts the IS curvechanges
the equilibrium level of output for each interest rate. An increase shifts the IS curve
outward; a decrease shifts it inward.

* The slope of the IS curve is

− ( 1−c (1−t)
b ) , or − bα1
G .
You can show this for yourself by simply writing i as a function of Y (the IS curve is drawn
with the interest rate, rather than the level of output, on the vertical axis).
MONEY, INTEREST, AND INCOME 110
111 CHAPTER 11

2.

Figure 111
DERIVING THE IS CURVE
 MONEY, INTEREST, AND INCOME 112

The Money Market and the LM Curve

This section reviews the requirements for equilibrium in the money market, and
derives the LM curvethe combinations of i and Y for which the supply of money
equals the demand for money.

The demand for money increases when people’s incomes rise, and decreases when
interest rates rise. The reason for the first is simple: When our incomes rise, we
need to hold more money in order to pay for the extra goods we buy. The reason we
want to hold less money when interest rates rise has to do with the opportunity
cost of holding money: when we choose to hold money, rather than keeping our
money in an interest bearing asset, we fail to earn the market rate of interest.
When interest rates rise, therefore, the cost of holding money instead of these other
assets rises, and we choose to hold less money.

The money demand function is written as follows:

L=kY− hi ,

where k and h are constants which reflect the sensitivity of money demand to
changes in income and in the interest rate, respectively. The function L represents
the demand for real balances (M/P). It does not represent the demand for
nominal balances (M); simple inflation shouldn’t affect it.

The supply of real balances is determined by two factors: the money supply, and the
price level. The money supply (M) is controlled by a country’s central bank (the
Federal Reserve System, or “Fed,” in the United States). The price level (P), as we
have already learned, is determined in both the long and the short run by the
interaction of aggregate supply and aggregate demand. We assume, for the
moment, that both the money supply and the price level are fixed, so that the supply
M̄
of real balances is constant at the level P̄ .

The LM curve shows all of

the combinations of output
and the interest rate for
which the market for real
money balances
is in equilibrium.

Figure 112
THE LM CURVE
113 CHAPTER 11

The combination of output and

the interest rate at which the
IS and LM curves intersect is
the only one that brings both
the goods market and the
money market into
equilibrium.

Figure 113
IS-LM EQUILIBRIUM

We can write the equilibrium condition

for the money market (the demand for
real balances must equal the supply of real balances) as

M̄ / P̄=kY−hi .

Solving this for i gives us the equation for the LM curve:

i=
1
h(kY−
M̄
P̄ ) .

Notice first that the LM curve is upward-sloping in Y, as the constants k and h are
positive.

M̄
Also note that an increase in real money balances ( P̄ ) will shift it outward
(downward) and that a decrease in real balances will shift it inward (upward).

Real balances can change either because nominal balances change (the money
supply changes), or because the price level changes. Because the AD curve is
graphed in P and Y, however, a change in the price level causes movement along the
AD curve rather than a shift in it.

3. Equilibrium in the Goods and Money Markets

The levels of output and the interest rate at which the IS and LM curves intersect
are the only ones for which both the goods market and the money market are in
equilibrium.
 MONEY, INTEREST, AND INCOME 114

A shift in either curve will change the equilibrium combination of Y and i.

4. Deriving the Aggregate Demand Schedule

This section derives the AD curve by varying the price level for which the LM curve
is drawn, and observing the way that this changes the IS-LM equilibrium. The
combinations of P and Y that result sketch a downward-sloping AD curve.

Graph It 11 gives you the opportunity to see this for yourself. As you change the
price level in order to generate the AD relationship, notice that you are holding the
money supply and the level of autonomous spending constant. Any change in these
variables, therefore, will cause the AD curve to shiftinward, if the level of income
that brings goods and money markets into equilibrium falls, and outward if this level
falls.

A change in the price level will just cause a movement along the AD curve.

5. A Formal Treatment of the IS-LM Model (optional section)

Since both the IS and the LM curves are described by linear equations, we can solve
these equations simultaneously to find the equilibrium levels of output and the
interest rate.

Combining the equations for the IS and LM curves and solving for both Y and i, we
find that

bαG M̄
( )
αG
Y= Ā+
1+kα G (b/h ) h+kbαG P̄

and

( )
kα G 1 M̄
i= Ā+
h+kbα G h+kbαG P̄ .

The fraction is called the fiscal policy multiplier. The fraction

is called the monetary policy multiplier. The equation for Y is also the equation
for the AD curve.

KEY TERMS
IS-LM model real money balances
IS curve demand for real balances
goods market equilibrium schedule central bank
LM curve aggregate demand schedule
money market equilibrium schedule fiscal policy multiplier
115 CHAPTER 11

monetary policy multiplier

GRAPH IT 11
The aggregate demand schedule describes the solutions of the IS-LM diagram for
different price levels. This Graph It asks you to show how, and why, changes in the
prices level affects ADi.e., why it slopes downward.

Chart 11–1 on the next page lines up an IS-LM diagram with an aggregate demand
diagram. We’ve drawn the IS curve, an LM curve based on the price level P 1, and
the equilibrium level of income (Y1*) which they mutually determine on the IS-LM
diagram. We’ve marked this same combination of income (Y1*) and the price level
(P1) on the AS-AD diagram below it, giving you one point on your AD curve.

You need to draw two more LM curves on the top graphone for a price level (P2)
greater than P1, and another for a price level (P0) less than P1, and to mark the
equilibrium levels of output that they, and the IS curve, determine.

Now drop vertical lines to mark the points (P0, Y0*) and (P2, Y2*) on the aggregate
demand diagram. When you connect the three points on the lower graph, you will
have an AD curve.
 MONEY, INTEREST, AND INCOME 116

Chart 111
DERIVING THE AD CURVE
117 CHAPTER 11

THE LANGUAGE OF ECONOMICS 11

Endogenous Variables Revisited

When we first made the distinction between endogenous and exogenous variables,
we had not yet worked with two equation systems. To make sure you are still
comfortable with this distinction in the more complicated models you now work
with, we provide this brief review.

Endogenous variables, you may remember, are determined within a particular

model. Typically, the more equations a model involves, the more endogenous
variables it is likely to havethe more variables it will determine.

Consider the IS-LM model: We take the price level as given (exogenously
determined), and find the levels of output and the real interest rate for which both
goods and money markets are in equilibrium. The levels of output and the interest
rate are determined endogenouslyby the interaction of all the other variables in
the model. Their values can never change unless one of these other variables
changes.

The same is true for the AS-AD modelthe price level and the level of output are
determined by the level of government spending, the taxes people are required to
pay, and the size of the money supply. They are also determined by the position and
slope of the AS curve. It is interesting to notice that the interest rate, which varies
along the AD curve (look again at Chart 10–1), is also endogenously determined; we
cannot change it without first changing the value of some other, exogenous variable.
Consumption and investment are also endogenous.

REVIEW OF TECHNIQUE 11

Solving a Two Equation System Graphically and Algebraically

In Review of Technique 5, we learned how to graph a linear equation. In this
Review of Technique, we discuss how to find the solution to two linear equations,
graphically and algebraically.

Consider the following two equations:

Y = aX + b, and X = cY + d

If we were to graph these, we would draw two curvesone for each equation. In
this instance, we would have one upward-sloping and one downward-sloping curve,
which, because of their different slopes, would be guaranteed to intersect.

We would have a very easy time solving these equations graphically: we would
simply find the point at which our lines crossed, and the values of X and Y that
defined that point. That would be our solution.

Solving these equations algebraically doesn’t involve much more than this: We
simply impose the assumption (or the requirement) that the values of X and Y are
 MONEY, INTEREST, AND INCOME 118

the same in both equations. Once we do this, we can substitute the value of X (or, if
we prefer, the value of Y) from one equation into the other, and solve for the
remaining variable. For example, we could write:
Y = a(cY + d) + b = acY + ad + b

and, solve as follows:

Y + (ac)Y = ad + b,

(1 + ac)Y = ad + b,

Y = (ad + b)/(1 + ac).

We could then plug this value of Y into either equation to find the solution for X:

X = c((ad + b)/(1 + ac)) + d,

X = c((ad + b)/(1 + ac)) + d((1 + ac)/(1 +

ac)),

X = ((cad  bc) + (d + cad))/(1 + ac),

X = (d  bc)/(1 + ac).

Algebraic solutions are particularly useful when we need to find quantitative, rather
than qualitative solutionsnumbers, rather than directions of change.

ACROSS
CROSSWORD
3 number of sections in this
chapter
4 policy, shifts LM curve
8 policy, shifts IS curve
11 type of variable, i
and Y are examples

DOWN
1 bank, determines monetary
policy
2 market, IS curve shows
equilibrium
119 CHAPTER 11

FILL-IN QUESTIONS
1. The IS curve describes all of
the combinations of output and the interest rate for which the ____________________
market is in equilibrium.

2. The IS curve is downward-sloping because a decrease in the interest rate

increases ____________________.
 MONEY, INTEREST, AND INCOME 120

3. An increase in the marginal propensity to consume (mpc), and hence an

increase in the multiplier G will make the IS curve ____________________.
4. The LM curve describes all of the combinations of output and the interest rate
for which the ____________________ market is in equilibrium.

5. The LM curve is upward-sloping because when people’s income rises, they want
to hold more ____________________. The increase in money demand drives up the
interest rate.

6. If money demand is relatively insensitive to the interest rate, the LM curve will
be quite ____________________.

7. If money demand is very sensitive to the interest rate, the LM curve will be
nearly ____________________.

8. ___________________ policy shifts the IS curve; ___________________ policy shifts the LM

curve.

9. The interest rate and level of output (under the assumption of a fixed price
level) are jointly determined by ____________________ for goods and money markets.

10. Any change in the equilibrium level of income in the IS-LM model, with the
exception of a change in the price level, will cause the ____________________ curve to
shift.

TRUE-FALSE QUESTIONS
T F 1. A change in the price level will shift the IS curve.

T F 2. For a given level of real money balances, there is a positive

relationship between interest rates and income along the LM curve.

T F 3. An increase in government spending will shift the IS curve outward

(up and to the right).

T F 4. An increase in the money supply will shift the LM curve outward

(down and to the right).

T F 5. Decreasing the money supply increases investment.

T F 6. For a given level of output, there can be more than one interest rate
for which the goods market is in equilibrium.

T F 7. For a given level of output there can be more than one interest rate
for which the money market is in equilibrium.

T F 8. An increase in the tax rate reduces the multiplier.

T F 9. The slope of the IS curve cannot be affected by policy decisions.

121 CHAPTER 11

T F 10. Equal increases in government purchases and transfers will shift the
IS curve by the same amount.

MULTIPLE-CHOICE QUESTIONS
1. Which component of aggregate demand is the main link between goods and
money markets?

a. consumption c. government spending

b. investment d. none of the above

2. Which of the following variables can shift the IS curve?

a. price level c. government spending

b. money supply d. none of the above

3. A change in the tax rate will

a. shift the IS curve c. both

b. change the slope of the IS curve d. neither

4. An increase in the price level will

a. increase real money balances d. decrease nominal money

b. decrease real money balances balances
c. increase nominal money
balances

5. Which of the following variables can shift the LM curve?

a. price level c. real money balances

b. money supply d. all of the above

6. For a fixed price level, a lower money supply leads to

a. higher income c. both

b. higher interest rate d. neither

7. An increase in the mpc will

a. make the IS curve steeper c. shift the IS curve outward

b. make the IS curve flatter d. have no effect on the IS curve

8. When investment is very sensitive to the interest rate, there will be a relatively

a. steep IS curve c. steep LM curve

b. flat IS curve d. flat LM curve

9. The less sensitive money demand is to changes in the interest rate, the more an
increase in the money stock will

a. increase AD b. lower interest rates

 MONEY, INTEREST, AND INCOME 122

c. both d. neither

10. Quick adjustment in the money market means that the economy is always on

a. the IS curve c. both

b. the LM curve d. neither

CONCEPTUAL PROBLEMS
1. Name all of the endogenous variables in the AS-AD model.

2. How are the IS-LM and AS-AD models related to each other?

3. What determines the slope of the IS curve? Will it be steeper or flatter in the
presence of a proportional income tax?

4. What determines the slope of the LM curve?

TECHNICAL PROBLEMS
1. Suppose that the following equations describe the economy:

(consumption)
(investment)

(demand for real money

balances)

Suppose also that government spending (G) is $550, taxes (T) are $500, and real
money balances (M/P) are $900.

(a) Write the formula for the IS curve.

(Hint: When the goods market is in equilibrium, .)

(b) Write the formula for the LM curve.

(Hint: When the money market is in equilibrium, the supply of real money
balances is equal to the demand for real money balances.)

(c) What are the equilibrium levels of output (Y), the real interest rate (i),
consumption (C), and investment (I)?

2. Now suppose that the government imposes a proportional income tax, so that

C=100+.8(Y −tY ) (consumption)

123 CHAPTER 11

(investment)

(demand for real money

balances)

If the t = .33 (there is a 33% income tax), government purchases (G) are $700,
and the real money supply (M/P) is $500,

(a) What is the formula for the IS curve?

(b) What is the formula for the LM curve?

(c) What is the initial value of the budget deficit?

(d) How large a change in the money supply would be necessary in order to
balance the budget?

(e) Why might this be a dangerous strategy for keeping the budget balanced in
the long run?