Principles of Macroeconomics

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Principles of Macroeconomics

• Economics 202
• Ryan Herzog

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Outline

• Chapter 12 Money, The Interest Rate, and Output
  Analysis and Policy

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Federal Reserve

• Stock Market
• Reacts negatively to the potential of future
  higher interest rates
• With the higher Federal Funds rate bonds prices
  decrease (inverse relationship) and bond yields
  increase
• Individuals are starting to hold bonds because of
  prices falling
• Bonds and stocks are substitutes

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Money Demand

• Downward Slope
• Transaction Motive
• Speculative Motive
• Opportunity cost
• As interest rates increase the cost of hold
  money, which does not earn interest, increases
• Bonds become more profitable

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Money Demand

• Determinants
• Price Level
• As prices increase individuals need to hold more
  money to buy the same amount of goods
• Income
• As incomes increase individuals will buy more
  goods, thus increasing their demand for money
• Interest Rates
• As interest rates decrease the cost of holding
  money decreases, thus the quantity of money
  demand increases

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Money Supply

• The quantity of money supplied is determined
  entirely by The Federal Reserve
• Reserve Rate
• Discount Rate
• Open Market Operations
• With money demand determines the equilibrium
  interest rate

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The Markets

• Goods
• Output and aggregate expenditures come together
  to determine the equilibrium level of income
• Money
• The market where financial assets are traded and
  the equilibrium interest rate is determined

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The Links

• Money demand depends on income (Y) which is
  determined in the goods market
• Investment (I) depends on the interest rate (r)
  which is determined in the money market

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Link 1 The Money Market

• What happens when there is an increase in income
• Money demand shifts right (increases)
• This creates an excess demand for money
• Banks increase interest rates
• What happens in the goods market?

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Link 2 The Goods Markets

• When interest rate increase
• The cost of borrowing money increases
• Firms lower their level of planned investment
• AE line shifts down
• Income decreases

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The Link

• Goods Market
• When equilibrium output/income (Y) changes in the
  goods market it will change money demand and thus
  interest rates in the money market
• Money Market
• When the equilibrium interest rate changes in the
  money market, investment will change in the goods
  markets

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Expansionary Policy

• Fiscal Policy
• Increase government spending or decrease taxes
• Aggregate expenditures (AE) increase
• Output / Income (Y) increases
• Money demand increases
• This causes interest rates (r) to increase
• Investment (I) decreases with higher interest
  rates
• AE and Y decrease

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Expansionary Policy

• Monetary Policy
• Fed increases the money supply (shifts right)
• The interest rate decreases
• A lower interest rate attracts investment, thus I
  increases
• AE and Y increase
• The increase in Y will cause money demand to
  increase
• The increase in money demand will raise interest
  rates, but by an amount less than the initial
  decrease

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Expansionary Fiscal Policy

• Government increases spending, AE shifts up and Y
  increases
• The increase in Y causes money demand to
  increase, increasing interest rates
• The increase in the interest rate lowers
  investment. The AE line shifts down to a lower Y

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Expansionary Fiscal Policy

• Crowding Out
• When government pursues expansionary policy it
  will eventually cause income to increase
• Because money demand depends on income, money
  demand and interest rates also increase
• This leads to a lower level of planned investment
• Thus government spending crowds out private
  investment

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Expansionary Monetary Policy

• Fed increases the money supply
• Interest rates decrease
• Investment increases (more profitable)
• Aggregate expenditure and output increase
• This causes money demand to increase
• Interest rates increase but by an amount less
  than the initial decrease

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Accommodation

• Government Spending
• Leads to increases in output, money demand, and
  interest rates
• The increase in interest rates is
  counterproductive for the governments goal of
  higher output
• Keynesians believed The Fed should counter this
  increase by increasing the money supply
• This keeps interest rates from increasing

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Accommodation
1. Government spending increases income, money
demand, and interest rates 2. The Fed increases
the money supply to prevent interest rates from
increasing 3. The Fed is accommodating the
government to prevent crowding out
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Contractionary Policy

• Fiscal Policy
• Government decreases spending or cuts taxes
• Aggregate expenditures (AE) decreases
• Output / Income (Y) decreases
• Money demand decreases
• This causes interest rates (r) to decreases
• Investment (I) increase with lower interest rates
• AE and Y increase

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Contractionary Policy

• Monetary Policy
• Fed decreases the money supply
• The interest rate increases
• A higher interest rate deters investment, thus I
  decreases
• AE and Y decrease
• The decrease in Y will cause money demand to
  decrease
• The decrease in money demand will lower interest
  rates, but by an amount less than the initial
  increase

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Contractionary Fiscal Policy

• Government decreases spending, AE shifts down and
  Y decreases
• The decrease in Y causes money demand to
  decrease, decreasing interest rates
• The decrease in the interest rate raises
  investment. The AE line shifts up to a higher Y

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Contractionary Monetary Policy

• Fed decreases the money supply
• Interest rates increases
• Investment decreases (less profitable)
• Aggregate expenditure and output decreases
• This causes money demand to decrease
• Interest rates decreases but by an amount less
  than the initial increase

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Policy Mix

• Government and The Federal Reserve are
  independent
• This causes their policies to, at times, compete
  against the other policy

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Summary

• Expansionary
• Fiscal
• Monetary
• Contractionary
• Fiscal
• Monetary

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Policy Mix
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Sensitivity

• Money Demand
• When income changes we know money demand changes,
  but we are unsure of how much
• The more sensitive money demand is to income, a
  small change in income will create relatively
  larger changes in money demand and interest rates

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Sensitivity

• Investment
• We know investment depends on the interest rate,
  but we are unsure of how much
• When investment is really sensitive to interest
  rates, a small change in the interest rate will
  create larger charges in investment
• The more sensitive investment is to changes in
  interest rates the larger the crowding out effect
  becomes