No Such Thing as a Free Lunch: Principles of Economics (Part 129)

All riches have their origin in mind. Wealth is in ideas - not money.

Robert Collier

Money, the Interest Rate, and Output: Analysis and Policy (Part A)

by

Charles Lamson

In previous posts, we discussed the market for goods and services---the goods market---without mentioning money, the money market, or the interest rate. We described how the equilibrium level of aggregate output (income) (Y) is determined in the goods market. At given levels of planned investment spending (I), government spending (G), and net taxes (T), we were able to determine the equilibrium level of output in the economy.

Also, in earlier posts, we discussed the financial market, or money market, barely referring to the goods market, as we explained how the equilibrium level of the interest rate is determined in the money market.

The goods market and the money market do not operate independently, however. Events in the money market affect what goes on in the goods market, and events in the goods market affect what goes on in the money market. Only by analyzing the two markets together can we determine the values of aggregate output (income) (Y) and the interest rate (r) that are consistent with the existence of equilibrium in both markets.

Looking at both markets simultaneously also reveals how fiscal policy affects the money market and how monetary policy affects the goods market. This is what we will do in the next several posts. By establishing how the two markets affect each other, we will show how open market purchases of government securities (which expand the money supply) affect the equilibrium level of national output and income. Similarly, we will show how fiscal policy measures (such as tax cuts) affect interest rates and investment spending.

The Links between the Goods Market and the Money Market

There are two key links between the goods market and the money market: 

• Link 1: Income and the Demand for Money The first link between the goods market and the money market exists because the demand for money depends on income. As aggregate output (income) (Y) increases, the number of transactions requiring the use of money increases. An increase in output, with the interest rate held constant, leads to an increase in money demand. Income, which is determined in the goods market, has considerable influence on the demand for money in the money market.

• Link 2: Planned Investment Spending and the Interest Rate The second link between the goods market and the money market exists because planned investment spending (I) depends on the interest rate (r). In earlier posts we assumed that planned investment spending is fixed at a certain level, but we did so only to simplify that discussion. In practice, investment is not fixed. Instead, it depends on a number of key economic variables. One is the interest rate. The higher the interest rate is, the lower the level of planned investment spending.The interest rate, which is determined in the money market, has significant effects on planned investment in the goods market. 

These two links are summarized in Figure 1.

FIGURE 1 Links between the Goods Market and the Money Market

Planned investment depends on the interest rate, and money demand depends on income.

Investment, the Interest Rate, and the Goods Market

It should come as no surprise that there is an inverse relationship between the level of planned investment and the interest rate.

When the interest rate falls, planned investment rises.

When the Interest rate rises, planned investment falls.

To see why this occurs recall that investment refers to a firm's purchase of new capital---new machines and plants. Whether a firm decides to invest in a project depends on whether the expected profits from the project justify its costs. Usually, a big cost of an investment project is the interest cost.

Consider a firm opening a new plant, or the investment required to open a new ice cream store. When a manufacturing firm builds a new plant, the contractor must be paid at the time the plant is built. When an entrepreneur decides to open a new ice cream parlor, freezers, tables, chairs, light fixtures, and signs are needed. These too must be paid for when they are installed.

The money needed to carry out such projects is generally borrowed and paid back over an extended period. The real cost of an investment project depends in part on the interest rate---the cost of borrowing. When the interest rate rises, it becomes more expensive to borrow, and fewer projects are likely to be undertaken; increasing the interest rate, ceteris paribus, is likely to reduce the level of planned investment spending. When the interest rate falls, it becomes less costly to borrow, and more investment projects are likely to be undertaken; reducing the interest rate, ceteris paribus, is likely to increase the level of planned investment spending.

We can now use the fact that planned investment depends on the interest rate to consider how this relationship affects planned aggregate expenditure (AE). Recall that planned aggregate expenditure is the sum of consumption, planned investment, and government purchases. that is:

AE ≡ C + I + G

We do know that there are actually many possible levels of I, each corresponding to a different interest rate. When the interest rate changes, planned investment changes. Therefore, a change in the interest rate (r) will lead to a change in total planned spending (C + I + G) as well.

We can summarize the effects of a change in the interest rate on the equilibrium level of output.

The effects of a change in the interest rate include:

• A high interest rate (r) discourages planned investment (I).

• Planned investment is a part of planned aggregate expenditure (AE).

•  Thus, when the interest rate rises, planned aggregate expenditure (AE) at every level of income falls.

•  Finally, a decrease in planned aggregate expenditure lowers the equilibrium output (income) (Y) by a multitude of the initial decrease in planned investments.

Using a convenient shorthand:

r ￪ ➡ I ⇩ ➡ AE ⇩➡ Y ⇩

r ⇩ ➡ I ￪ ➡ AE ￪ ➡ Y ￪   

As you see, the equilibrium level of output (Y) is not determined solely by events in the goods market, as we assumed in our earlier simplified discussions. The reason is that the money market affects the level of the interest rate, which then affects planned investment in the goods market. There is a different equilibrium level of Y for every possible level of the interest rate (r). The final level of equilibrium Y depends on what the interest rate turns out to be, which depends on events in the money market.

Money Demand, Aggregate Output (Income), and the Money Market

We have just seen how the interest rate---which is determined in the money market---influences the level of planned investment spending and thus the goods market. Now let us look at the other half of the story: the ways in which the goods market affects the money market.

We also saw in previous posts that the demand for money depends on the level of income in the economy. More income means more transactions, and an increased volume of transactions implies a greater demand for money. With more people earning higher incomes and buying more goods and services, more money will be demanded to meet the increased volume of transactions. An increase in income therefore shifts the money demand curve to the right. (Review Figure 5.)

If, as we are assuming, the Federal Reserve's (Fed's) choice of the amount of money to supply does not depend on the interest rate, then the money supply curve is simply a vertical line. The equilibrium interest rate is the point at which the quantity of money demanded equals the quantity of money supplied. This equilibrium is shown at a 6 percent interest rate in Figure 4. If the amount of money demanded by households and firms is less than the amount in circulation as determined by the Fed, as it is at an interest rate of 9 percent in Figure 4, the interest rate will fall. If the amount of money demanded is greater than the amount in circulation, as it is at an interest rate of 3 percent in Figure 4, the interest rate will rise.

The equilibrium level of the interest rate is not determined exclusively in the money market. Changes in aggregate output (income) (Y), which take place in the goods market, shift the money demand curve and cause changes in the interest rate. With a given quantity of money supplied, higher levels of Y will lead to higher equilibrium levels of r. Lower levels of Y will lead to lower equilibrium levels of r, as represented in the following symbols: 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 515-519*

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