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Transcript
Chapter 9 1 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 Chapter 9 2 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 Chapter 9 3 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 Chapter 9 4 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. Chapter 9 5 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 Chapter 9 6 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 Chapter 9 7 about more as a result of Federal Reserve reactions than income-driven shift in money demand. Chapter 9 8 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 Chapter 9 9 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. Chapter 9 10 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 Chapter 9 11 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 Chapter 9 12 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 Chapter 9 13 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 Chapter 9 14 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 Chapter 9 15 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.