Download Start with government purchases of goods and services, and with

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The principal determinant of investment spending is the interest rate. Once we
know what the interest rate is, we can use what we already know about the
consumption function, government purchases, and net exports to calculate the
equilibrium level of national product and employment. But what determines the
interest rate? To figure out the interest rate you need to look at the Federal
Reserve--the central bank of the United States--and at what is going on in
financial markets. You need to look at what economists call the money market.
Money has three functions: a store of value, a unit of account, and a medium of
exchange. Money's store-of-value function is not important; there are better--and
more important--stores of value. Money's unit-of-account function is important-it is what makes deflation such a catastrophe for an economy and part of what
makes a currency crisis such a dangerous episode. But money's medium-ofexchange function is the most important for our purposes, because money as
medium of exchange is the key link between the financial markets and the real
economy. People need money if they are going to spend. And if they do not have
enough money they will borrow more, and so bid up interest rates.
But let's bring this discussion to a temporary halt, for we must first clear up what
could turn into an important mistake: an extremely infelicitous mode of
expression by economists that has brought a great deal of grief to a great number
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of students of economics in the past half-century.
In everyday conversation the word money has the clear and distinct meaning of
wealth. We say, "He has a lot of money." Or we sometimes use money to mean
income, as in "She makes a lot of money." Less frequently we also use money to
mean cash--"Do you have any money?"--but we much more frequently use the
word cash when we are talking about dollar bills in a wallet. And we occasionally
use the word money to mean liquid assets--wealth in a form in which we can
readily spend it. That is, we sometimes--although rarely these days--hear people
say, "I can't buy that. I don't have any money: my wallet is empty of cash, my
checking account balance is very low, I don't feel like paying the substantial
penalty for early withdrawal on my certificate of deposit, and my VISA card is
balance is at its limit."
Guess what meaning economists always give to the word money? Yep. It's the last
of these definitions. When economists say money, they always mean liquid
wealth, wealth in a form in which it can readily be spent. An asset is money if it
is readily spendable purchasing power. To an economist, your money includes
your cash, your checking and saving account balances, your money market
mutual funds (and your reserve deposits at the local branch of the Federal
Reserve). But your money is never your total wealth, your income, or even the
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value of the dollar bills in your wallet.
Why do economists use the word money in this way? And why do economics
textbooks use the word in this peculiar, nonintuitive, contrary-to-plain-English
way? I don't know! In my lectures, I try to use the term liquidity where textbooks
use money. But most of your textbooks will use the word money when they mean
liquid wealth. Be careful. Don't let them confuse you. (And remember that
economists also use the word investment in a non-intuitive, technical way: don’t
let them confuse you with respect to what they mean by investment either.)
The class of liquid assets--that is, what economists term money--is the economic
grease that keeps the cycle of expenditure and income running. In the absence of
such liquidity, buying and selling would seem almost impossible: a lawyer could
buy shoes from a cobbler only when the cobbler at the same time needed
someone to represent him in court. But with our system we are confident that we
can buy anything, as long as we have the money. An adequate amount of money
is the key to keeping the flow of purchases of any household or business from
uncomfortable interruptions. People go to substantial sacrifices to make sure
they have adequate money balances to carry out their transactions. So when
people or businesses find that they are short of liquid purchasing power--of
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money--they sell off other chunks of wealth or borrow to boost their transaction
balances. And as they increase their borrowing, they push the interest rate up.
Just what, exactly, are your “transactions balances”? All economists agree that
cash in your pocket and the balance in your checking account are transactions
balances. But what about money in your savings account? You can use it to buy
things almost as easily as you can use cash in your pocket. But the bank could—if
it were desperate—invoke its legal right to hang onto your savings account
balances for weeks or months if it were itself short of liquid assets. And what
about those assets which you could turn into cash in your pocket in five minutes
if you wanted to, but which are subject to what bankers politely call a
“substantial penalty for early withdrawal”? They could be transactions balances if
you really needed them…
Economists, especially those who call themselves monetarists, have argued over
these and similar questions for nearly 90 years. They have coined the term “M1”
for the narrow definition of transactions balances—cash plus checking
accounts—and they have coined the term “M2” for the broader definition—the
one that includes savings account balances. (There are also even broader
measures called “M3” and “L” that we won’t worry about here.) Some think one
is a better measure of liquid assets, some think the other.
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Whatever your definition of liquid assets—M1, M2, or something else--when you
hold liquid assets you are paying a price. The cash in your pocket does not pay
any interest or dividends while you carry it around. The balance in your
checking account pays no, or at most a trivial, rate of interest. Even savings
account deposits pay lower rates of return on average than does wealth invested
in the bond market or the stock market. The more readily spendable a kind of
wealth is, the lower the rate at which it earns interest or accumulates dividends
and capital gains. The higher the current interest rate is, the more interest you
lose and the more eager you are to keep your money balances relatively low.
9-Appendix: the LM curve
The LM curve plots how the interest rate changes as national product changes,
i.e., at what level the money market would set the interest rate for each level of
national product. We saw before how the money demand and money supply
curves determine the interest rate. But where the money demand curve was on
the graph depended on the level of national product: Consider a different level of
national product, and you have a different interest rate. The LM curve
summarizes the information in the whole family of money demand-money
supply diagrams--a different diagram for each level of national product. A
higher level of national product shifts the money demand curve to the right and
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produces a higher interest rate. Thus the LM curve slopes upward.
The level of the interest rate depends not just on the level of national product
(which shifts the money demand curve) but also on the determinants of the real
money supply: the price level, the Federal Reserve policy, the currency-todeposits ratio, and the reserves-to-deposits ratio. Anything that increases the real
money supply will lower the equilibrium interest rate for any level of national
product. Anything that decreases the money supply will raise the interest rate.
Thus whatever shifts the money supply shifts the LM curve also: Things that
reduce the money supply shift the LM curve to the left; things that increase the
money supply shift the LM curve to the right.
Was monetary policy in 1996 expansionary or contractionary? Did the LM curve
shift left or right? The answer depends on which measure of the money supply
you look at. Things were simpler a generation ago. Then all monetary aggregates
moved together and the financial system constrained demand more than it does
today.
Also, the Federal Reserve today targets interest rates and not the money supply.
The higher the level of national product, the higher the Fed pushes interest rates.
There is an upward-sloping line that captures the relationship between national
product and the interest rate produced in the financial markets, but it comes
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about more as a result of Federal Reserve reactions than income-driven shift in
money demand.
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Start with government purchases of goods and services, and with net exports.
Add the consumption function. Then add the investment determined by the
current long-term real interest rate. As we discussed in Topic 6, these pieces of
information allow us to determine where equilibrium is on the incomeexpenditure diagram. They allow us to calculate the level of aggregate demand
at which inventories are neither unexpectedly built up (leading firms to cut back
production) nor unexpectedly drawn down (leading firms to expand
production). This level of aggregate demand is the level at which national
product will tend to settle, and is the economy's goods market equilibrium
Note that each value of the interest rate leads to a different goods market
equilibrium level of national product (or GDP). The higher the interest rate, the
lower will be the equilibrium level of the national product
The diagram has the (long-term real) interest rate on the vertical axis, and the
level of national product on the horizontal axis. It contains a downward-sloping
line that shows, for each x-axis value of the interest rate, what the y-axis value of
national product is that is the economy's goods market equilibrium.
This diagram is called an IS diagram. The line describing the relationship between
the interest rate and the equilibrium level of output is called the IS curve, where
IS is supposed to remind you of investment-savings. Summarizing the relationship
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between the interest rate, the level of the aggregate demand line on the incomeexpenditure diagram, and the equilibrium level of national product into one
single line--the IS curve--seems to be well worth doing because it pulls together a
large chunk of any introductory macroeconomics course into a single, easily
digested package.
You can construct the IS curve off of the income expenditure diagram, as in
Figure 7.1. In the figure, the topmost panel shows the income-expenditure
diagram, with a different aggregate demand line (and thus a different goodsmarket equilibrium level of national product) for each potential value of the
interest rate. The higher the long-term real interest rate, the lower investment is,
and thus the lower the aggregate demand line on the income-expenditure
diagram--and the lower the equilibrium level of national product.
The bottom panel shows how this relationship generates the downward-sloping
IS line: the higher the interest rate, the lower is the level of national product.
Anything that increases or decreases the sensitivity of investment spending to
the interest rate will flatten or steepen the IS curve. Anything that increases or
decreases the marginal propensity to spend will also flatten or steepen the IS
curve, because then a given shift in interest rates and in investment spending
will generate a change in national product that is larger or smaller, respectively.
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General optimism that leads to an investment boom or expansionary fiscal policy
that raises government purchases (or cuts taxes) will shift the IS curve to the
right; general pessimism or contractionary fiscal policy that cuts government
purchases (or raises taxes) will shift the IS curve to the left.
Animal spirits.
Fluctuations in investment spending are the primary cause of the business cycle-again, fluctuations in production and unemployment--which pushes real GDP
up as high as 5 percent above potential output in booms or as low as 9 percent
below potential output in deep recessions. (And pushes it even deeper during
Great Depressions.)
As we have seen, one important cause of fluctuations in investment spending are
changes in interest rates. High interest rates discourage investment by
diminishing the present value of the profits businesses hope investments will
generate. A business invests hoping that investment is the way to make more
money in the future. The managers of a business serve at the pleasure of its
board of directors. The board of directors is elected by the shareholders. A
business that does not think it can earn more money by investing in new plant
and equipment will pay its earnings out to its shareholders instead: it will boost
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its dividends. Better not to risk buying machines and building buildings when
interest rates are high.
But a business whose managers see a way to expand the business or to cut costs
and produce profits that more than match the market rate of return will invest.
When interest rates are lower, more and more types of investment projects have
positive net present values--in other words, they will earn more for the
corporation than loaning the money out to someone else. Hence more and more
investment projects promise to make profits for the businesses that undertake
them; thus, total investment is higher when interest rates are low.
A second important cause of fluctuations in investment spending are changes in
investors' relative degree of optimism--changes in what John Maynard Keynes
called the "animal spirits" of investors. Optimism on the part of investors-whether rational optimism or irrational exuberance--can lead to high investment,
even when interest rates are very high. In contrast, pessimism on the part of
investors can lead to low levels of investment, even when interest rates are very
low.
Why do the money market and the interest rate play such a central a role in
macroeconomics? Perhaps the best way to think about it is that the interest rate
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in our modern market economy has two things to do:
First, the interest rate is the price of liquid assets. That is, it is the price at which the
demand by consumers and businesses to hold wealth in readily spendable form
is equal to the supply of readily spendable assets that the economy's banking
system can provide. Every person or business must decide how much liquid
wealth he or she wishes to hold. Demand for money depends on the interest rate:
the higher the interest rate, the lower the demand for money because the greater
the interest that people are giving up when they keep wealth in readily
spendable form. Whenever the demands for money of consumers and businesses
exceed the supply of liquid assets provided by the banking system, the interest
rate rises; conversely, whenever supply exceeds demand, the interest rate falls.
Second, there is an important sense in which the interest rate is the price of
investment. When the interest rate is low, the long-term benefits far in the future
from undertaking investments are high. Every business thinking about making
an investment must at some point face the question: Is this investment worth
making? In other words, is it better to make this investment or to take the money
that would be used to finance this investment and loan it out to somebody else?
The answer to this question depends on the interest rate. The higher the interest
rate you can get when you loan your money out, the greater the chance that the
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right answer to this business question will be not to make the investment.
Thus, investment is high when interest rates are low, and investment is low
when interest rates are high. Because of the multiplier, low interest rates and
high investment mean that national product is high as well; conversely, high
interest rates and low investment mean that national product is low as well.
The interest rate thus has to do two jobs: it is supposed to both set supply and
demand equal in the money market and keep the amount of investment high
enough to avoid a recession. There is no guarantee that the same interest rate will
accomplish both purposes. Thus we need a Federal Reserve--that is, a central
bank--for there is no reason why the interest rate that balances supply and
demand for liquid assets should be the same as the interest rate that generates
the level of investment that guides the economy to full employment.
The Federal Reserve exists to tweak interest rates by changing the banking
system's ability to supply liquid assets. As the Federal Reserve enables the
banking system to supply more liquid assets, interest rates fall. As the Federal
Reserve reduces the banking system's ability to supply liquid assets, interest
rates rise. The Federal Reserve is always intervening in the money market as it
tries to get the interest rate to the level at which national product will be large
enough to generate full employment, without being so large as to generate
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accelerating inflation.
The policy mix.
What is the policy mix?
Monetary policy controlled by the Federal Reserve determines the interest rate.
Fiscal policy, controlled by Congress and the president, shifts the IS curve.
Together they make up the policy mix. A mix of expansionary fiscal and
monetary policies generates high national product and moderate interest rates.
Tight fiscal and monetary policies generate low national product and moderate
interest rates.
Moderate levels of national product can be achieved in many ways: The figure
shows how to do so by contractionary fiscal policy (with expansionary monetary
policy), and by expansionary fiscal policy (with contractionary monetary policy).
Benefits of loose fiscal-tight monetary policy
Does it matter whether a given level of national product and employment is
obtained via a policy mix that has relatively expansionary monetary policy (and
contractionary fiscal policy) or one that has relatively contractionary monetary
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policy (and expansionary fiscal policy)? Yes, for makers of economic policy care
about other things than the level of national product alone. A policy mix biased
toward more expansionary monetary policy mix has lower interest rates. This
matters for the international sector: The exchange rate is lower, hence net exports
are higher. Lower interest rates mean that investment spending is higher, hence
long-run productivity growth is higher--and lower interest rates are preferable if
there is a reason to think that higher investment is desirable.