Macroeconomic Links: Interest rates, Output and Inflation

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Macroeconomic Links Interest rates, Output and
Inflation

• Class 12

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We learned how the interest rate is determined.
Now, we discuss what the interaction of interest
rates and output

• Its All Connected
• Y C I G AE
• Money Demand Money Supply interest
  rate (r)
• The interest rate, r, can affect Y
• and Y can affect the interest rate
• 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.

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The keys to the link

• r and Y
• Money supply inversely related to the interest
  rate
• Greater income Greater transaction demands
• Greater Money Demand (shifts to the right)
• Y positively related to Money Demand, positively
  related to interest rates
• Investment (I) depends on r
• Why?
• How?
• I is inversely related to r

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What happens if the interest rate increases?

• r
• Investment will go down.
• When I goes down, output goes down
• The reverse is true, too

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What happens when Y increases?

• Y
• Households make more transactions with greater
  income
• Transaction demand goes up, money demand shifts
  up (right)
• r goes up
• And the reverse is true, too

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Monetary policy can affect Y. Fiscal policy can
affect r

• Expansionary and Contractionary
• Expansionary
• Expansionary fiscal policy is either an increase
  in government spending or a reduction in net
  taxes aimed at increasing aggregate output
  (income) (Y).
• Expansionary monetary policy is an increase in
  the money supply aimed at increasing aggregate
  output (income) (Y).
• Contractionary
• Contractionary fiscal policy refers to a decrease
  in government spending or an increase in net
  taxes aimed at decreasing aggregate output
  (income) (Y).
• Contractionary monetary policy refers to a
  decrease in the money supply aimed at decreasing
  aggregate output (income) (Y).

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Expansionary fiscal policy not so simple

• Expansionary Fiscal Policy
• Either G goes up or T goes down
• When G goes up, Y goes up!
• The government spending multiplier
• But those multipliers were assuming nothing else
  changed particularly, that interest rates did
  not change
• Real world multipliers must be modified when both
  the interest rate (and price level) are allowed
  to change

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The crowding-out effect occurs when an increase
in government spending crowds out some of the
private investment spending

• Crowding Out
• Y increases less than if r did not increase

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Expansionary Monetary Policy

• Increase the Money Supply
• Increase the money supply, interest rates go down
• Because money demand also goes
• up, the interest rates decrease
• less than if money demand
• did not increase

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What if we combine expansionary fiscal policy
with expansionary monetary policy?

• Fed Accommodation
• An expansionary fiscal policy (higher government
  spending or lower taxes) will increase aggregate
  output (income).
• Higher income will shift the money demand curve
  to the right, and put upward pressure on the
  interest rate.
• If the money supply were unchanged following an
  increase in the demand for money, the interest
  rate would rise.
• But if the Fed were to accommodate the fiscal
  expansion, the interest rate would not rise.

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Contractionary fiscal policy

• Decrease G or increase T
• At first
• But then, money demand shifts down (left)
• So output does not shift down as much as before
  (when interest rates were constant)

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Contractionary monetary policy

• Money Supply Shifts Down (Left)
• At first
• But then, money demand shifts down
• So interest rates do not rise as much as before
  AND output will not fall as much

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Now, lets throw price changes into the mix, too!

• Increase in Price Level
• Price level goes up, my coffee now costs 2
  instead of 1.
• I need to carry more money in my pocket
• Demand for Money shifts up (right)
• Inverse relationship between Y and P a
  negatively sloped aggregate demand curve
• We already built the AD curve because of changes
  in real wealth
• Another reason for negative AD curve is because
  of interest rate changes

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The AD curve is Zen-like everything (except for
prices) is in equilibrium at every point

• Zen and the AD Curve
• At all points on this curve,
• both the goods market and the
• money market are in equilibrium
• Final step finding the equilibrium price level

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What can cause a shift in the AD curve?

• Shifts in AD
• An increase in the quantity of money supplied at
  a given price level shifts the aggregate demand
  curve to the right.
• An increase in government purchases or a decrease
  in net taxes shifts the aggregate demand curve to
  the right.

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Aggregate supply is the total supply of all goods
and services in the economy.

• AS
• Graph that shows the relationship between the
  aggregate quantity of output supplied by all
  firms in an economy and the overall price level.
• There is a different AS curve for the short run
  and the long run
• In the short run, the aggregate supply curve (the
  price/output response curve) has a positive
  slope.

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In the short run, the relationship between price
levels and aggregate output vary widely

• Short Run AS
• At low levels of aggregate output, the curve is
  fairly flat.
• As the economy approaches capacity, the curve
  becomes nearly vertical.
• At capacity, the curve is vertical.
• When the economy is operating at low levels of
  output, an increase in aggregate demand is likely
  to result in an increase in output with little or
  no increase in the overall price level
• Why?
• Lag in price changes
• As the economy approaches maximum capacity, firms
  respond to further increases in demand only by
  raising prices.

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Short Run AS
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What can cause a shift in the AS curve?

• Supply Shocks
• Costs
• Technological change
• Regulation
• Weather

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The equilibrium price level is the point at which
the aggregate demand and aggregate supply curves
intersect.

• Equilibrium
• P0 and Y0 correspond to equilibrium in the goods
  market and the money market and a set of
  price/output decisions on the part of all the
  firms in the economy.

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In the long run, there are no lags between prices
and costs

• Long Run AS
• Costs lag behind price-level changes in the short
  run, resulting in an upward-sloping AS curve.
• Costs and the price level move in tandem in the
  long run, and the AS curve is vertical.
• Y0 represents the level of output that can be
  sustained in the long run without inflation.
• Also called potential output or potential GDP.

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Policy and Prices

• Expansionary Policy
• Lets say there is an increase in the money
  supply, a tax cut, or an increase in government
  spending.
• Expansionary policy works well when the economy
  is on the flat portion of the AS curve, causing
  little change in P relative to the output
  increase.

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Policy and Prices

• Expansionary Policy (continued)
• On the steep portion of the AS curve,
  expansionary policy does not work well. The
  multiplier is close to zero.
• When the economy is operating near full capacity,
  an increase in AD will result in an increase in
  the price level with little increase in output.

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In the long run, policy will not affect aggregate
output

• Long Run
• Bullets

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Now, we can really understand causes of inflation

• Inflation
• Recall change in price level

• Demand-pull inflation is inflation initiated by
  an increase in aggregate demand.

• Cost-push, or supply-side, inflation is inflation
  caused by an increase in costs.

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Supply-side inflation is really hard to deal with

• Supply side inflation
• Lets say there is a cost shock
• The government sees the decrease in output and
  responds with expansionary policy
• Prices have gone WAY up, output hasnt increased
• Stagflation

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Next Class

• Linking Inflation and Unemployment
• Sample Midterm

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Sentence

• Title
• Bullets