Planned Investment and the Interest Rate No longer assume planned investment is xed Investment refers to a rm s purchase of new capital new machines and plants When manufacturing rm builds new plant the contractor must be paid at time plant is built Money needed to carry out such projects is generally borrowed and paid back over extended period real cost of an investment project depends on interest rate cost of borrowing When interest rate rises it becomes more expensive to borrow and fewer projects are likely to be undertaken Increasing interest rate ceteris paribus reduces level of planned investment spending When interest rate falls it becomes less costly to borrow and more investment projects are undertaken Reducing interest rate ceteris paribus increases level of planned investment spending Relationship between interest rate and planned investment is illustrated by downward sloping curve higher the interest rate lower the level of planned investment Other Determinants of Planned Investment Expectation of future sales if rm expects that it s sales will increase in future it may begin to build up its capital stock invest now so that it will be able to produce more in the future to meet increased level of sales Planned Aggregate Expenditure and the Interest Rate We can use fact that planned investment depends on interest rate to consider how planned aggregate expenditure AE depends on interest rate AE C I G At higher interest rate planned investment is lower so planned aggregate expenditure shifts downward Recall a fall in any component of aggregate spending has an even larger or multiplier effect on equilibrium income Y Summary A high interest rate r discourages planned investment I Planned investment is a part of planned aggregate expenditure AE Thus when interest rate rises planned aggregate expenditure AE at every level of income falls A decrease in planned aggregate expenditure lowers equilibrium output income Y by a multiple of the initial decrease in planned investment Shorthand r Iv AEv Yv rv I AE Y Equilibrium in Both the Goods and Money Markets The IS LM Model When income Y increases this shifts money demand curve to the right which increases interest rate r with a xed money supply IS LM model Given the interest rate the equilibrium level of output can be determined from the goods market Given output the equilibrium interest rate can be determined from the money market Y Md r Yv Mdv rv Policy Effects in the Goods and Money Markets Expansionary Policy Effects Expansionary scal policy an increase in government spending or a reduction in net taxes aimed at increasing aggregate output income Y Expansionary monetary policy an increase in money supply aimed at increasing aggregate output income Y Expansionary Fiscal Policy An Increase in Government Purchases G or a Decrease in Net Taxes T Consider increase in gov purchases G of 10 billion This increase in expenditure causes rm s inventories to be smaller than planned Unplanned inventory reductions stimulate production and rms increase output Y Consumption also increases because added output means added income some of which is spent As aggregate outcome income Y increases an impact is felt in the money market the increase in income Y increases demand for money Md Resulting disequilibrium with quantity of money demanded greater than quantity of money supplied causes interest rate to rise Increase in G raises both Y and r Increase in r has side effect higher interest rate causes planned investment spending I to decline Decrease in I works against increase in G Crowding out effect tendency for increases in gov spending to cause reductions in private 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 I Size of crowding out effect and ultimate size of gov spending multiplier depends on several things rst if we assume the Fed expanded quantity of money to accommodate increase in G the multiplier would be larger In this case the higher demand for money would be satis ed with higher quantity of money supplied and interest rate would not rise Crowding out effect depends on interest sensitivity or insensitivity of planned investment responsiveness of planned investment spending to changes in interest rate Interest sensitivity means that planned investment spending changes a great deal in response to changes in interest rate while interest insensitivity means little or no change in planned investment as result of changes in interest rate Effects of expansionary scal policy G Y Md r Iv Y increases less than if r didn t increase Expansionary Monetary Policy An Increase in the Money Supply First open market operations inject new reserves into the system and expand quantity of money supplied money supply curve shifts to right Because quantity of money supplied is greater than amount households want to hold equilibrium interest rate falls Planned investment increases when interest rate falls Increased planned investment spending means planned aggregate expenditure is now greater than aggregate output Firms experience unplanned decrease in inventories and they raise output Y An increase in money supply decreases interest rate and increases Y However the higher level of Y increases demand for money demand for money curve shifts to right which keeps interest rate from falling as far as it would otherwise Effects of expansionary monetary policy Ms rv I Y Md r decreases less than if Md did not increase Contractinary Policy Effects Contractionary Fiscal Policy A Decrease in Government Spending G or an Increase in Net Taxes T Decrease in gov purchases or increas in net taxes leads to decrease in aggregate output income Y a decrease in the demand for money Md and a decrease in interest rate r The decrease in Y Is less than it would be if we did not take money market into account because decrease in r also causes planned investment I to increase This increase offsets some of decrease in planned aggregate expenditure brought about by decrease in G Effects of contractionary scal policy Gv or T Yv Mdv rv I Y decreases less than if r did not decrease Mdv r Iv Yv Mdv r increases less than if Md did not decrease Contractionary Monetary Policy A Decrease in the Money Supply Macroeconomic Policy Mix Expansionary scal and monetary Y C Expansionary scal and contractionary monetary r Iv Contractionary scal and monetary Yv Cv Contractionary scal and
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