No Such Thing as a Free Lunch: Principles of Economics (Part 130)

If one sentence were to sum up the mechanism driving the Great Stagnation, it is this: Recent and current innovation is more geared to private goods than to public goods. That simple observation ties together the three major macroeconomic events of our time: growing income inequality, stagnant median income, and the financial crisis. 

Tyler Cowen

Money, the Interest Rate, and Output: Analysis and Policy

(Part B)

by

Charles Lamson

Combining the Goods Market and the Money Market

Expansionary Policy Effects

Any government policy aimed at stimulating aggregate output (income) (Y) is said to be expansionary. An expansionary fiscal policy is an increase in government spending (G) or a reduction in net taxes (T) aimed at increasing aggregate output (income) (Y). An expansionary monetary policy is an increase in the money supply aimed at increasing aggregate output (income) (Y).

Expansionary Fiscal Policy: An Increase in Government Purchases (G) or Decrease in Net Taxes (T) As you know from earlier posts, government purchases (G) and net taxes (T) are the two tools of government fiscal policy. The government can stimulate the economy---that is, it can increase aggregate output (income) (Y) either by increasing government purchases or by reducing net taxes. Though the impact of the tax cut is somewhat smaller than the impact of an increase in G, both have a multiplier effect on the equilibrium level of Y.

Consider an increase in government purchases (G) of $10 billion. This increase in expenditure causes firms' inventories to be smaller than planned. Unplanned inventory reductions stimulate production, and firms increase output (Y). However, because added output means added income, some of which is subsequently spent, consumption spending (C) also increases. Again, inventories will be smaller than planned and output will rise even further. The final equilibrium level of output is higher by a multitude of the initial increase in government purchases.

This multiplier story is incomplete, however. Until this post, we have assumed that planned investment (I) is fixed at a certain level, but we now know that planned investment depends on the interest rate. We can now discuss what happens to the multiplier when investment varies because we now have an understanding of the money market, in which the interest rate is determined.

The increase in r has a side effect---a higher interest rate causes planned investment spending (I) to decline. Because planned investment spending is a component of planned aggregate expenditure (C + I + G), the decrease in I works against the increase in G. An increase in government spending (G) increases planned aggregate expenditure and increases aggregate output, but a decrease in planned investment reduces planned aggregate expenditure and decreases aggregate output.

This tendency for increases in government spending to cause reductions in private investment spending is called the crowding-out effect. Without any expansion in the money supply to accommodate the rise in income and increased money demand, planned investment spending is partially crowded out by the higher interest rate. The extra spending created by the rise in government purchases is somewhat offset by the fall in planned investment spending. Income still rises, but the multiplier effect of the rise in G is lessened because of the higher interest rate's negative effect on planned investment.

Note that the size of the crowding-out effect and the ultimate size of the government spending multiplier depend on several things. First, we assume the Fed did not change the quantity of money supplied. If we were to assume instead that the Fed expanded the quantity of money to accommodate the increase in G, the multiplier would be larger. In this case, the higher demand for money would be satisfied with a higher quantity of money supplied, and the interest rate would not rise. Without a higher interest rate, there would be no crowding out. 

Second, the crowding-out effect depends on the sensitivity or insensitivity of planned investment spending to changes in the interest rate. Crowding out occurs because a higher interest rate reduces planned investment spending. Investment depends on factors other than the interest rate, however, and investment may at times be quite sensitive to changes in the interest rate. If planned investment does not fall when the interest rate rises, there is no crowding-out effect.

These effects are summarized next.

Effects of an expansionary fiscal policy:

Exactly the same reasoning holds for changes in net taxes. The ultimate effect of a tax cut on the equilibrium level of output depends on how the money market reacts. The expansion of Y that a tax cut brings about will lead to an increase in the interest rate and thus a decrease in planned investment spending. The ultimate increase in Y will therefore be less than it would be if the interest rate did not rise.

Expansionary Monetary Policy: An Increase in the Money Supply Now let us consider what will happen when the Fed decides to increase the supply of money through open market operations. At first, open market operations inject new reserves into the system and expand the quantity of money supplied (the money supply curve shifts to the right). Because the quantity of money supplied is now greater than the amount households want to hold, the equilibrium rate of interest falls. Planned investment spending (which is a component of planned aggregate expenditure) increases when the interest rate falls.

Increased planned investment spending means planned aggregate expenditure is now greater than aggregate output. Firms experience unplanned decreases in inventories, and they raise output (Y). An increase in the money supply decreases the interest rate and increases Y. However, the higher level of Y increases the demand for money (the demand for money curve shifts to the right), and this keeps the interest rate from falling as far as it otherwise would. 

If you review the sequence of events that follows the monetary expansion, you can see the links between the injection of reserves by the Fed into the economy and the increase in output. First, the increase in the quantity of money supply pushes down the interest rate. Second, the lower interest rate causes planned investment spending to rise. Third, The increased planned investment spending means higher planned aggregate expenditure, which means increased output as firms react to unplanned decreases in inventories. Fourth, the increase in output (income) leads to an increase in the demand for money (the demand for money curve shifts to the right), which means the interest rate decreases less than it would have if the demand curve for money had not increased.

Effects of an expansionary monetary policy:

The power of monetary policy to affect the goods market depends on how much of a reaction occurs at each link in this chain. Perhaps the most critical link is the link between r and I. Monetary policy can be effective only if I reacts to changes in r. If firms sharply increase the number of investment projects undertaken when the interest rate falls, expansionary monetary policy works well at stimulating the economy. If, however, firms are reluctant to invest even at a low interest rate, expansionary monetary policy will have limited success. In other words, the effectiveness of monetary policy depends on the slope of the investment function. If it is nearly vertical, indicating very little responsiveness of investment to the interest rate, the middle link in this chain is weak, rendering monetary policy ineffective. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 519-523*

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