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2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Links Between the Goods Market
and the Money Market
The goods and money markets do not
operate independently. 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.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl 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.
An increase in aggregate
output (income) shifts the
money demand curve,
which raises the
equilibrium interest rate
from 7 percent to 14
percent.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Link 2: Planned Investment
and 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
falls, planned investment
rises, and when the
interest rate rises, planned
investment falls (fewer
projects are likely to be
undertaken).
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Interest Rate and Planned
Aggregate Expenditure
An increase in the
interest rate from 3
percent to 6 percent
lowers planned
aggregate
expenditure and
thus reduces
r I AE Y equilibrium income
from Y0 to Y1.
r I AE Y
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Money Demand, Aggregate Output
(Income), and the Money Market
The equilibrium interest
rate is not determined
exclusively in 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
Y M d
r
rate.
Y M d
r
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Expansionary Policy Effects
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Crowding-Out Effect
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Effectiveness of Monetary Policy
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl 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), shift the
money demand curve to
the right, and put upward
pressure on the interest
rate.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Fed Accommodation of an
Expansionary Fiscal Policy
If the money supply were
unchanged, the interest rate
would rise. But if the Fed
were to accommodate the
fiscal expansion, the
interest rate would not rise.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Contractionary Policy Effects
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Contractionary Policy Effects
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Contractionary Monetary Policy
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Contractionary Monetary Policy
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Macroeconomic Policy Mix
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Appendix: The IS-LM Diagram
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Appendix: The IS-LM Diagram
An increase in government
spending shifts the IS
curve to the right.
This increases the value of
both Y and r.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Appendix: The IS-LM Diagram
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Appendix: The IS-LM Diagram