Lecture 9

Money Interest and Income
Money plays an central role in the determination of income and employment.

Interest rates are a significant determinant of aggregate spending, and the
Federal Reserve, controls money growth and interest rates.
This chapter introduces
• Money and monetary policy
• Builds an explicit framework of analysis within which to study the interaction
of goods markets and assets market.
• What Determines interest rate?
• What is the role of interest rate in the business cycle?
THE GOODS MARKET AND THE IS CURVE
• The IS curve (or schedule) shows combinations of interest rates and levels of output such that
planned spending equals income.
• The IS curve is derived in two steps.
• First, we explain why investment depends on interest rates.
• Second, we insert the investment demand function in the aggregate demand
• THE INVESTMENT DEMAND SCHEDULE
• So far, investment spending ( I ) has been treated as entirely exogenous—some number like
$1,000 billion, determined altogether outside the model of income determination.
• Now, as we make our macro model more complete by introducing interest rates as a part of the
model, investment spending, too, becomes endogenous. The desired or planned rate of
investment is lower the higher the interest rate.
THE INVESTMENT DEMAND SCHEDULE
• Investment is spending on additions to the firm’s capital, such as machines or buildings.
• Typically, firms borrow to purchase investment goods. The higher the interest rate for such
borrowing, the lower the profits that firms can expect to make by borrowing to buy new
machines or buildings, and therefore the less they will be willing to borrow and invest.
• Conversely, firms will want to borrow and invest more when interest rates are lower.
INVESTMENT AND THE INTEREST RATE
• We specify an investment spending function of the form
I = ¯I - bi Where, b > 0 ……………………………(1)
where i is the rate of interest and the coefficient b measures the responsiveness of investment
spending to the interest rate.
¯I now denotes autonomous investment spending, that is, investment spending that is independent
of both income and the rate of interest
Equation (1) states that the lower the interest rate, the higher is planned investment. If b is large,
then a relatively small increase in the interest rate generates a large drop in investment spending
INVESTMENT AND THE INTEREST RATE
• The schedule is negatively sloped to reflect
the assumption that a reduction in the
interest rate increases the profitability of
additions to the capital stock and therefore
leads to a larger rate of planed investment
spending.
• The position of the investment schedule is
determined by the slope—the coefficient b in
equation (1)—and by the level of autonomous
investment spending. If investment is highly
responsive to the interest rate, a small decline
in interest rates will lead to a large increase in
investment, so the schedule is almost flat.
Conversely, if investment responds little to
interest rates, the schedule will be more
nearly vertical.
THE INTEREST RATE AND AGGREGATE DEMAND: THE IS CURVE
• Aggregate demand still consists of the demand for consumption, investment, government
spending on goods and services, and net exports, only now investment spending depends on the
interest rate
• From equation (2) we see that an increase in the interest rate reduces aggregate demand for a
given level of income because a higher interest rate reduces investment spending. Note that − A ,
which is the part of aggregate demand unaffected by either the level of income or the interest
rate, does include part of investment spending, namely, − I . As noted earlier, − I is the
autonomous component of investment spending, which is independent of the interest rate (and
income)
THE INTEREST RATE AND AGGREGATE DEMAND: THE IS CURVE
The Interest Rate and AD: The IS Curve
AD  A  c(1  t )Y  bi
• Derive the IS curve
 Consider a lower interest rate, i2
 Shifts the AD curve upward to AD’ with an intercept of A  bi
2
 Given the increase in AD, the equilibrium shifts to point E 2, with an associated income level of
Y2
 Plot the pair (i2, Y2) in panel (b) for another point on the IS curve
• We can apply the same procedure to all levels of i to generate additional points on the IS curve
• All points on the IS curve represent combinations of i and income at which the goods market
clears  goods market equilibrium schedule
• Figure 10-5 shows the negative relationship between i and Y
• Downward sloping IS curve

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Money Interest and Income

Money plays an central role in the determination of income and employment.

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