7.

Money and interest rates

7.1 Asset equilibrium, reviewed

7.2 IS-LM model
7.3 Price and aggregate demand
 The demand for money

Recall that the demand for real cash

balances depends on income and the real
interest rate.
L = L(Y, r)
+,
(In the long run, income is assumed to be
given at YF. In the short-run, however, we
know Y is variable, since it depends on E.)
 Asset-market equilibrium
Equilibrium in the asset market:
M/P = L(r, Y)
(The money supply M and price level P are given.)

If income rises, real demand for money exceeds

real supply:
demand for bonds falls; bond prices fall
interest rates rise
demand for money falls back
equilibrium is restored
 r The asset-market
and
interest rates
rise as a A higher income must be
result. r1 associated with a higher
interest rate if the asset
market is to be in equilibrium.

r0
When income
rises demand
for money
rises

L (r, Y1 )
L (r, Y0 )

M/ P L, M/P
 r The asset-market
When money
supply
increases

r0
interest
rates fall for
the same
r1
level of
income.

L (r, Y0 )

M/ P M/P L, M/P
 The LM curve
Assume a specific form of money-demand:
M/P = L1Y L2r.
r = (1/L2)M/P + (L1/L2)Y
This implies the following:
If Y increases, r rises (as discussed).
If M increases, the whole curve shifts right.
If P increases, the whole curve shifts left.
 r The LM curve
LM
bond prices fall
and interest rates rise
to restore equilibrium.

r1

r0

When income
increases, demand for
money increases

Y0 Y1 Y
7.2 IS-LM model
 The situation so far
For a given interest rate, r, the IS curve
determines spending and income.
For a given income, Y, the LM curve determines
the interest rate, r.
So, Y and r cannot be determined independently of
each other, but must be set simultaneously.
IS-LM model: what is the pair of r and Y so that
saving equals investment and the asset market
is in equilibrium at the same time?
 Algebraically

IS: Y = m (a + G + I bT ) mhr.
LM: r = (1/L2)M/P + (L1/L2)Y

must be solved simultaneously for the two

variables, (r, Y).
Graphically
 r The IS-LM model
LM (M/P)

r0

IS (G, T, I)

Y0 Y
 r A rise in G or I
LM (M/P)

r1

r0

IS (G, T, I)
IS (G, T, I)

Y0 Y1 Y
 A rise in G or I
It is still true that this raises spending and
hence income.
Modification: but as it raises income, it also
raises interest rates.
So it discourages that part of investment that is
sensitive to interest rates, choking off some
of the increase in income (crowding out).
(Income does not increase by the full extent of
the multiplier.)
 A rise in G
Now, unlike before, a rise in G is not an
unadulterated benefit.
Although it raises spending and income,
higher G discourages private investment,
since it raises interest rates.
Then a choice must be made between
government spending and private
investment spending.
 Increasing money supply

An increase in money supply lowers interest

rates.
This raises investment and spending.
Therefore it raises income and output.
An increase in the price level acts like a fall
in money supply.
It raises interest rates, reduces investment,
spending and income.
 r A rise in M
LM (M/P)

LM (M/P)

r0
A higher money supply
r1 lowers interest rates and
raises income and output.

IS (G, T, I)

Y0 Y1 Y
 Fiscal policy

The overall purposes of taxation and

government spending are threefold:
(a) provide public goods
(b) redistribute income and achieve equity
(c) help stabilise output and employment
 Public goods
Public goods are those whose benefits, when
provided to one are necessarily provided to all
(e.g., national defence, the administration of
justice, street lighting, bridges, urban roads).
As a result, there is little incentive for private
people to pay for them (free-rider problem).
So, government must finance these through
compulsory means, i.e., taxes.
 Equity and poverty alleviation
Similar to public goods, everyone would benefit
from a society less afflicted with inequity and
poverty, but few would contribute fully to it
voluntarily.
Social justice or equity is a public good.
Progressive taxation and spending to achieve this.
(Affluent pay proportionately more and receive
proportionately less than the poor.)
 Macroeconomic stabilisation

Keynes showed that public spending

fulfilled an additional macroeconomic
function, namely, making up for the
fluctuations of private spending.
Taxation T

Government spending on consumption G

or on investment I
Money and deficit finance
Sell bonds
to finance deficit

Bangko Sentral

Government
Treasury
Sell bonds Pay with new money
to finance deficit

Pay with General public

existing money & commercial banks
balances
 Interaction between fiscal
and monetary policy
Co-ordination between BSP and national
government (NG) is important.
If NG decides to run a larger deficit (higher G or
lower T ), then it issues new bonds (IS shifts
right).
If BSP buys these, it expands M and holds
interest rate constant (LM shifts).
If BSP stands back, M remains constant (LM
does not move).
 Recall: a rise in G or I
r
LM (M/P)

r1

r0

IS (G, T, I)
IS (G, T, I)

Y0 Y1 Y
 Ar rise in G with higher M
LM (M/P)
Monetary LM (M/P)
policy keeps
interest
rates
constant
r10

IS (G, T, I)
IS (G, T, I)

Y0 Y1 Y
income increases
by the full multiplier
 Interaction between fiscal
and monetary policy
If BSP keeps money supply constant as
NG expands fiscally, interest rates rise and
private investment in crowded out.
Big difference: if the BSP fully
accommodates the fiscal expansion by
expanding money, interest rates do not
rise. There is no crowding out, and the
effect of fiscal policy is much greater.
THIS CONCLUDES THE
MATERIAL FOR THE
2. EXAM
7.3 Price and aggregate demand
 IS-LM and aggregate demand

Aggregate demand (output as a function of

the price level) is implied by the IS-LM
model.
To see this, answer the question:
How does a change in the price level
affect output?
 An increase in P
Remember: an increase in P affects the
model through the LM curve.
A higher P is like having a lower money
supply.
r = (1/L2)M/P + (L1/L2)Y
Graphically, it shifts the LM curve to the
left.
A higher P reduces spending
r LM (M /P)
LM (M /P)

r1

r0

IS
Y
Y0

P
P

AD

Y1 Y0
Y
 A higher P reduces spending

A higher P reduces real money supply

(with M constant).
Real demand for money exceeds supply;
bond prices fall (interest rates rise).
Investment spending falls.
Spending falls.
Hence the AD curve is downward-sloping.
 Reducing money shifts AD

A smaller money supply shifts the LM curve

to the left.
r = (1/L2)M/P + (L1/L2)Y
But this means a lower Y for every level
of r.
So it is associated with a shift of the AD
curve to the left.
A lower M shifts AD left
r LM (M /P)
LM (M /P)

r1

r0

IS
Y
Y0

AD(M)
AD(M)
Y1 Y0
Y
 Price and consumption

Thus far, we have only allowed price to

affect spending through investment (i.e.,
higher prices, smaller real money stock,
higher interest rates, lower investment).
But price can also affect spending directly
through consumption (Pigou effect).
 Price and consumption

Previously:
C = a + b (Y T )
says consumption depends on income.
But it is also possible consumption depends
on real wealth, or real money balances.
C = a + b (Y T ) + e (Z /P)
where Z is nominal wealth, including money.
 Price level and consumption

This means that as prices rise, the IS curve

also shifts to the left.
 A lower M shifts AD left

How this happens:

A lower M raises interest rates at all price
levels. (Why?)
This reduces investment at all price levels.
Therefore it reduces spending at all price
levels.
A higher G or lower T shifts AD right
r
LM (M /P)

r1

r0 IS(G)

IS(G)
Y
Y0

AD(G)
AD(G)
Y0 Y1
Y
 A higher G or lower T shifts AD right

How this happens:

A higher G or lower T raises spending and
interest rates at all price levels
(Even if it reduces I somewhat, there is still
a total increase in spending.)
So total spending increases at all price
levels: the AD curve shifts to the right.
 Summary

In the IS-LM model, a change in income

resulting from a change in the price level
represents a movement along the
aggregate demand curve.
A change in income for a fixed price level
represents a shift in the aggregate
demand curve.
Putting it all together
 Transition from short- to long-run

Claim: If prices are given the chance to

adjust, long-run equilibrium at full
employment will be attained.
Claim: The price level tends to fall if
spending is below full employment. It
tends to rise if spending is above full
employment.
 Transition from short- to long-run

In the short run, prices are slow to adjust.

So, the effect of a demand shock falls
mostly on output. This causes output to
fall below or rise above full employment in
the short run.
But ultimately, as price levels catch up
(rising or falling), output returns to full
employment is restored.
 Short and long run
r
LRAS
Demand shock quickly reduces
output below full employment;
prices remain constant

SRAS

as prices change
AD
(slowly) full employment
is regained
AD

Y
 Short and long run
r
LRAS
Demand shock quickly raises
output above full employment;
prices remain constant

but prices rise (slowly)

and output falls back to SRAS
full employment.

AD
AD

Y
 A supply shock, e.g., higher
oil prices
r
LRAS
Prices rise rapidly, reducing
aggregate demand and
output

SRAS

SRAS

but prices fall (slowly)

and output ultimately AD
returns to full
employment level.

Y
 Essence of the policy debate over
government intervention
Conservative line: no need for government
intervention; automatic mechanism will ensure
full employment is regained. (In addition a
dislike for enlarging scope of government,
displacing private investment, etc.)
Keynesian argument: How long (if at all) will it
take prices to change so that full employment is
regained? In the long run, we are all dead.
(Argument for government intervention through
fiscal and monetary policy)
End