Topic 5 Money Interest Rate and Income Policy Analysis

� INTRODUCTION

Can you recall what you have learned in Topic 3? In that topic we discussed the goods market in which the equilibrium level of aggregate output (Y) is determined. For specific levels of planned investment (I), government spending (G), taxes (T), one should be able to determine the equilibrium level of output in the economy. Also in Topic 4, we have discussed the money market, in which the equilibrium level of interest rate is determined. These two markets are actually interrelated, where events in both markets have important effects on each other. By examining the two markets together, we can determine the values of aggregate output (Y) and interest rate (r) that are consistent with the existence of equilibrium in both markets.

TTooppiicc

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� Money, Interest Rate and Income: Policy Analysis

By the end of this topic, you should be able to:

1. Discuss the link between the goods market and the money market;

2. Analyse the effects of expansionary and contractionary fiscal policy on the economy;

3. Analyse the effects of expansionary and contractionary monetary policy on the economy; and

4. Summarise the implementation of a mixed policy.

LEARNING OUTCOMES

� TOPIC 5 MONEY, INTEREST RATE AND INCOME: POLICY ANALYSIS

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Income (Y) (in the Goods Market)

Demand for Money (Md) (in the Money Market)

At the same time, the implementation of fiscal policy and monetary policy will affect both the money market and the goods market, provided that we analyse both markets simultaneously. Specifically, we will examine how the monetary policy affects the equilibrium level of output and income. We will also analyse how the implementation of fiscal policy affects interest rates and investment spending. Let us learn these matters in the following subtopics.

RELATIONSHIP BETWEEN THE GOODS MARKET AND THE MONEY MARKET

In general, there are two important connections between the goods market and the money market. The first link is between iincome and the demand for money. How are they related? In the previous topic we saw that demand for money depends on income. When income increases, the demand for money also increases as more transactions are carried out. With an interest rate that is held constant, an increase in output level will lead to an increase in money demand. In short, we can say that income which is determined in the goods market will have a significant influence on the demand for money in the money market. Let us look at the first link (Figure 5.1).

Figure 5.1: The first link How about the second link? The second link is between pplanned investment and the interest rate. How are they related? In Topic 3, we assumed that the planned investment is fixed at a certain level, but in reality investment is not fixed but depends on several variables. One of the variables is interest rate. When the interest rate is high, the planned investment level is low. In short, we can say that the interest rate, which is determined in the money market, will have a significant influence on the planned investment in the goods market. This relationship can be simplified as in Figure 5.2.

5.1

TOPIC 5 MONEY, INTEREST RATE AND INCOME: POLICY ANALYSIS � 111

Interest rate (r) (in the money market)

The planned investment (I)(in the Goods Market)

Figure 5.2: The second link

Further explanation of the link between those two markets, the goods and the money markets, is given in the next subtopics. Let us continue!

5.1.1 Income, Demand for Money and Interest Rate

In Topic 4, we saw that the money demand depends on the level of income in the economy. More income means more transactions, and therefore leads to a higher demand for money. The equilibrium level of interest rate is given by the intersection between money supply and money demand as shown in Figure 5.3.

(a)

(b)

Figure 5.3: Money market equilibrium

At point E1, the money market is in equilibrium where Md = Ms at r = 5%. When there is an increase in aggregate output (Y), the demand for money will increase. The money demand curve shifts to the right as shown in Figure 5.3 (b). At an interest rate of 5% there is an excess demand for money and the interest rate will rise from 5% to 8%.

ACTIVITY 5.1

Compare TWO links between the goods market and the money market.


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Obviously, we can see that the equilibrium level of interest rate is not determined solely in the money market but also in the goods market. An increase in aggregate output (Y) shifts the money demand curve and therefore leads to a change in the interest rate.

In short we can say;

5.1.2 Investment, Interest Rate and Income

Do you know that the relationship between interest rate and the planned investment can be negative? This happens when the interest rate falls, the planned investment rises and vice versa. Why is this so? Before firms undertake certain projects, they will compare the cost and the expected profit of the projects. If the expected profit is greater than the cost, then firms will undertake the projects. The money needed to carry out the projects is usually borrowed and will be paid after a certain period of time. The cost of borrowing, which is reflected by the interest rate, is part of the real cost of an investment project. If the interest rate increases, this means that the cost of borrowing is higher; thus, fewer projects will be undertaken. Conversely if the interest rate falls, the cost of borrowing is lower and more investment projects will be undertaken. This relationship is shown in Figure 5.4.

(a)

(b)

Figure 5.4: Relationship between investment and income

Y�

Md �

r �

Y �

Md �

r �

or


As can be seen in Figure 5.4 (a), the relationship between the interest rate and planned investment is a downward-sloping curve. The higher the interest rate, the lower the level of planned investment. At an interest rate of 5%, planned investment is I0. When the interest rate falls, from 5% to 2%, planned investment increases from I0 to I1. When the interest rate increases from 5% to 8%, planned investment falls from I0 to I2.

From here we will see how planned investment, which depends on the interest rate, affects planned aggregate spending, which is the sum of consumption, planned investment and government spending. As mentioned earlier, when the interest rate changes, planned investment also changes and therefore leads to a change in aggregate planned expenditure.

A drop in interest rate from 5% to 2% leads to an increase in investment from I0 to I1. A change in investment from I0 to I1 will affect aggregate expenditure, shown by an upward shift in the AE curve. Output also will increase from Y0 to Y1; that is, an increase of �I x investment multiplier (1/(1-mpc).

In short we can say;

Obviously we can see that the equilibrium level of output (Y) is not determined solely by events in the goods market but also in the money market. Changes in the money market affect the interest rate level, which then affects planned investment in the goods market.

r �

I �

Y �

r �

I �

Y�

or

SELF-CHECK 5.1

After discussing the relationship between the goods market and the money market, what do you think the effect of increasing investment spending is?


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GOODS MARKET AND MONEY MARKET

Once we fully understand the links between the goods market and money market, we can proceed to analyse the two markets simultaneously. To see how the two markets interact, we will examine the effects of changes in fiscal and monetary policy to the economy. Specifically, the equilibrium levels of aggregate output (Y) and the interest rate (r) will be determined when variables such as government spending (G), taxes (T) and the money supply (Ms) changes, whether by increasing or decreasing. First, we will discuss fiscal policy and see what will happen when the government implements (i) expansionary fiscal policy, (ii) contractionary fiscal policy. Second, we will discuss monetary policy and analyse the impact on the economy when the government implements (i) expansionary monetary policy, (ii) contractionary monetary policy.

5.2.1 Fiscal Policy Analysis

In this subtopic, we analyse how the economy is affected by fiscal policy, which involves changes in government spending (G) or changes in taxes (T). This action aims to influence aggregate output (Y). (a) EExpansionary Fiscal Policy: An Increase in G or a decrease in T

Firstly let us look at the meaning of expansionary fiscal policy.

As mentioned before, there are two tools of government fiscal policy. The government can stimulate the economy and increase aggregate output (Y) either by increasing government spending or by reducing taxes. Nevertheless, the impact of a tax cut is smaller than the impact of an increase in government spending. As you may recall from Topic 4, the multiplier effect for the government spending is 1/(1-mpc) while the multiplier for tax is mpc/(1-mpc). To see it clearly, let us say there is an increase in government spending (G) of RM20 million. An increase in government spending causes firmsÊ inventories to be less than planned investment. As this happens, production and output increase. An increase in output means that income also increases and this end up with an increase in consumption spending and saving. Once again, inventories will be smaller than planned and output

Expansionary Fiscal Policy is an increase in government spending (G) or a decrease in taxes (T) aimed to increase aggregate output (Y).

5.2


will definitely increase even more. At the end, the equilibrium level of output will be higher and it is a multiple of the initial increase in government spending, or (�G � 1/1-mpc).

In Topic 4, the planned investment (I) is assumed as being fixed. However, the planned investment actually depends on the interest rate. As government spending increases, output/income (Y) will increase and this will have an impact on the demand for money (Md) and therefore the money market. Assuming that the central bank does not increase the money supply, the money market will be in disequilibrium as Md > Ms, and the interest rate will increase. Thus, the initial increase in government spending will lead to an increase in Y and r as shown here.

At the same time, an increase in r will create a side effect where a higher interest rate will cause planned investment (I) to decrease. An increase in government spending (G) increases planned aggregate expenditure (C+I+G) and leads to an increase in aggregate output (Y). However, a decrease in planned investment due to a higher interest rate reduces planned aggregate expenditure and decreases aggregate output (Y). The reduction in private investment spending as a result of an increase in government spending is known as the „crowding out effect‰. If the money supply is held constant, a rise in income, and therefore in money demand, will lead to a reduction in planned investment spending as the interest rate increases. So what does it mean by crowding out effect?

G �

Y �

Md � ( sM )

r �

Crowding out effect is a reduction in private investment that occurs because of an increase in government spending.


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The crowding out effect can be seen in Figure 5.5. An increase in government spending from G0 to G1 shifts the planned aggregate expenditure upward from (C+I+G0) to (C+I+G1). The new equilibrium point is at E1, and income increases from Y0 to Y1. This causes the money demand to increase and the money market will be in disequilibrium as can be seen in Figure 5.5 (a). The increase in money demand raises the interest rate (r) from r0 to r1 and investment will decrease from I0 to I1. With lower investment, the new planned aggregate expenditure shifts downward and the equilibrium level of income will be at point E2 � Y2.

(a)

(b)

Figure 5.5: Crowding out effect

However, the crowding out effect depends on the sensitivity of planned investment spending to changes in the interest rate, as can be seen in Figure 5.6. If the planned investment is sensitive to changes in the interest rate, the crowding out effect will be larger. On the other hand, if it is not sensitive at all, there will be no crowding out effect.

(a)

(b)

Figure 5.6: Crowding out effects on planned investment


The effects of an expansionary fiscal policy can be summarised as follows:

(b) CContractionary Fiscal Policy: A decrease in G or an Increase in T The government can use this policy to reduce inflation in the economy. The government can use contractionary fiscal policy by reducing

government spending (G) or increasing taxes (T). Both are used to decrease aggregate output (Y). So what does it mean by contractionary fiscal policy?

However, if we take into account the money market, a decrease in government spending (G) or an increase in taxes (T) leads to a decrease in aggregate output (Y), a decrease in the money demand (Md) and subsequently a decrease in the interest rate (r). As this happens, the

G �

Y �

Md � ( sM )

r �

I � Y �

Contractionary Fiscal Policy is a decrease in government spending (G) or an increase in taxes (T) aimed at decreasing aggregate output (Y).

EXERCISE 5.1

1. Discuss how the crowding out effect occurs. 2. Explain how the sensitivity of the planned investment spending to

changes in interest rate influences the crowding out effect?


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reduction in aggregate output (Y) will be less as a decrease in the interest rate (r) causes planned investment (I) to increase. Increasing planned investment offsets some of the decrease in planned aggregate expenditure brought about the decrease in government spending (G). The effects of a contractionary fiscal policy can be summarised as follows:

5.2.2 Monetary Policy Analysis

In this section, we will look at how the economy is affected by monetary policy, which involve changes in the money supply. This action aims to influence aggregate output (Y). The government can use either expansionary monetary policy or contractionary monetary policy to influence the economy. (a) EExpansionary Monetary Policy: An Increase in Money Supply The government can use an expansionary monetary policy to stimulate

economy through an increase in money supply. As mentioned in Topic 4, this can be done through several ways. Let us say the government decides to do this through open market operations. By doing this, the money supply increases and the money supply curve shifts to the right. As the quantity of money is now greater than what people want to hold, the interest rate falls. Consequently, planned investment spending increases and this will lead to an increase in planned aggregate expenditure. An increase in the money supply causes the interest rate to fall and output (Y) to increase. At a higher level of income, the demand for money increases. This means that the interest rate will not fall as far as it otherwise would. In other words, we can say that,

G �

Y �

Md � ( sM )

r �

I � Y �


The effects of an expansionary monetary policy can be summarised as follows:

However, the effectiveness of the monetary policy depends on the sensitivity of investment spending to changes in the interest rate. If investment is sensitive to changes in interest rate, for example a fall in interest rate which induces firms to invest more; the expansionary monetary policy will be effective in stimulating the economy. Conversely, if investment is not sensitive to changes in interest rate, an expansionary monetary policy will not be very effective. The effectiveness of monetary policy depends on the shape of the investment function as shown in the previous Figure 5.6.

Expansionary Monetary Policy is an increase in money supply (Ms) aimed to increase aggregate output (Y).

Ms �

r �

I �

Y � Md �

ACTIVITY 5.2

The government can use monetary policy to influence the economy.Explain how the interest rate sensitivity of investment demand can affectthe effectiveness of the policy.


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(b) CContractionary Monetary Policy: A Decrease in Money Supply Firstly, let us look at its definition.

The government can use a contractionary monetary policy by reducing the money supply (Ms) in order to decrease aggregate output (Y). When the money supply increases, the interest rate falls. Planned investment spending is negatively related to the interest rate. With a higher interest rate, planned investment is less and therefore the aggregate expenditure also is lower, which leads to a lower equilibrium level of output (Y). As the level of output (Y) is lower, demand for money will also be lower. The effects of a contractionary monetary policy can be summarised as follows:

A MIX OF FISCAL AND MONETARY POLICY

In the previous sections we have seen both policies, fiscal and monetary, separately. However the government can use these two policies simultaneously. For instance, the government can use expansionary fiscal policy, that is by increasing government spending (G) together with expansionary monetary policy, that is by increasing the money supply. Increasing government spending (G) alone will increase both aggregate output (Y) and the interest rate (r) while increasing the money supply alone will increase aggregate output (Y) but decrease the interest rate (r). Thus, if the objective of the government is to

5.3

Ms �

r �

I �

Y � Md �

Contractionary Monetary Policy is a decrease in the money supply (Ms) aimed at decreasing aggregate output (Y).


increase Y but keep the interest rate constant, it can achieve this objective by increasing both government spending (G) and the money supply (Ms) by a certain amount. In other words,

� The goods market and money market operate interdependently. Any events in the goods market will affect the goods market and vice versa.

� There are two important links between the goods market and the money market; i) the level of income (Y), which is determined in the goods market, determines the volume of transactions each period and therefore affects the money demand (Md) in the money market and ii) the interest rate, which is determined in the money market, affects the level of planned investment in the goods market.

� Planned investment and the interest rate are negatively related as the interest rate determines the cost of investment projects.

� With different interest rate values, planned investment spending and equilibrium level of output are different.

Policy Mix is the combination of fiscal and monetary policies in use at a given time to achieve certain objectives, that is increase output (Y) and keep the interest rate (r) constant.

ACTIVITY 5.3

The implementation of a mixed policy of fiscal and monetary policies can be used by the government to avoid the crowding out effect. Discuss this matter in a group.


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� The use of fiscal and monetary policies can be summarised as:

Policy G T Ms

Expansionary Fiscal Policy � �

Contractionary Fiscal Policy � �

Expansionary Monetary Policy �

Contractionary Monaetary Policy �

� The policy mix is the implementation of both fiscal and monetary policies to achieve certain objectives, that is increase output (Y) and interest rates (r) constant.

Contractionary fiscal policy

Contractionary monetary policy

Crowding out effect

Demand for money

Expansionary fiscal policy

Expansionary monetary policy

Goods market

Income

Interest rate

Investment

Money market

Policy mix

Documents

Topic 5 Money Interest Rate and Income Policy Analysis