Chapter Twenty Eight
Money, the Interest Rate,
and Output: Analysis
and Policy
Links Between the Goods
Market and the Money Market
Income, which is determined in the
goods market, has considerable
influence on the demand for money in
the money market.
The interest rate, which is determined
in the money market, has significant
effects on planned investment in the
goods market.
Planned Investment Schedule
Interest
Rate
15%
10%
5%
I1
I0
I2
Planned
Investment
The Effects of a Change in the
Interest Rate
 A high interest rate (r) discourages
planned investment (I)
 Planned investment is part of planned
aggregate expenditure (AE)
 When the interest rate rises, planned AE
at every level of income falls
The decrease in planned AE lowers
equilibrium output (Y) by a multiple of the
initial increase in planned I.
The Effect of an Interest Rate Increase on
Planned AE
C+I0+G
(r=3%)
Aggregate
Planned
Expenditures
C+I1+G
(r=6%)
45o
Y1
Y0
Aggregate
Output
Equilibrium in the Money Market
Interest
Rate
MS
Excess supply of
money
Excess demand
for money
9
6
3
Md
M d1
Money, M
The effect of an increase in income
(Y) on the interest rate (r) ...
Interest
Rate
9
6
MS
Excess demand
for money
M1d (Y=Y1)
M0d (Y=Y0)
Money, M
Summary
Md
Y
r
I
AE
Md
Y
r
r
I
Y
r
AE
Y
Suppose Expansionary Fiscal Policy...
Fiscal policy which is aimed at
increasing the level of equilibrium
output
Increase in government expenditures
Decrease in taxes
Aggregate
Planned
Expenditures
C+I0+G0
(r=r0)
Y0
Aggregate Output
Aggregate
Planned
Expenditures
Expansionary Fiscal Policy
G1 > G0
C+ I0+G1
(r=r0)
C+ I0+G0
(r=r0)
Y0
Y1
Aggregate
Output
Aggregate
Planned
Expenditures
Increase in r will cause decrease in I
I 1 < I0
C+ I +G
0
(r=r0)
1
C+ I1+G0
(r=r1)
C+ I0+G0
(r=r0)
Y0
Y1
Aggregate
Output
What happened?
Increase G implies increase Y
Increase Y implies increase Md
Increase Md implies increase r
Increase r implies decrease I
Decrease I implies decrease AE
Crowding Out
Crowding Out
Increase in G leads to
decrease in I
Y increases less than if r did
not increase
Effects of an Expansionary Fiscal Policy:
G
Y
r
Md
I
(but Y increases less than if r did not increase)
Effects of an Expansionary Monetary Policy:
MS
r
I
Y
d
M
(but r decreases less than if Md did not increase)
Fed Accommodation of an
Expansionary Fiscal Policy
Interest
Rate
M0 S
M1 S
r1
r0
M1d
M0d
Money, M
Effects of a Contractionary Fiscal Policy:
G
Y
r
Md
I
(but Y decreases less than if r did not decrease)
Effects of a Contractionary Monetary Policy:
MS
r
I
Y
d
M
(but r increases less than if Md did not decrease)
Policy Mix
Policy mix refers to the combination
of monetary and fiscal policies in use
at a given time.
Determinants of Planned
Investment
 The interest rate
 Expectations of future sales
 Capital utilization rates
 Relative capital and labor costs
Review Terms & Concepts
 Contractionary fiscal
 Expansionary
policy
 Contractionary
monetary policy
 Crowding-out effect
 Expansionary fiscal
policy
monetary policy
 Goods market
 Interest sensitivity of
planned investment
 Money market
 Policy mix