Difficulty: Intermediate | Prerequisites: Chapter 11 (money demand, money supply, the Fed), Chapter 8 (aggregate expenditure model, multiplier)
This is the chapter where the two halves of the introductory macro model finally talk to each other. Up to now you have studied the goods market (where output and income are determined) and the money market (where the interest rate is determined) more or less in isolation. Chapter 12 connects them and shows that a change in one market ripples into the other. If you have not reviewed the multiplier, money demand, and how the Fed controls the money supply, do that first.
The goods market sets aggregate output (Y) and the money market sets the interest rate (r). They are linked by two channels: income affects money demand, and the interest rate affects planned investment. A change in either market therefore feeds back into the other until a new joint equilibrium is reached.
Goods market
The market in which the equilibrium level of aggregate output (income) is determined. Equilibrium condition: Y = C + I + G.
In simple terms, this is where total spending equals total production.
Money market
The market in which the equilibrium interest rate is determined. Equilibrium condition: M^d = M^s (money demand equals money supply).
Think of it as the place where the "price" of holding money (the interest rate) settles.
Planned investment (I)
The amount firms intend to spend on new capital, inventory, and equipment. It depends (inversely) on the interest rate and on other factors such as expected sales and capacity utilisation.
In simple terms, when borrowing is cheaper, firms plan to invest more.
Planned investment schedule (curve)
A graph plotting the interest rate against the level of planned investment. Normally it slopes downward: lower rates, higher investment.
Think of it as the demand curve for investment spending, with the interest rate on the vertical axis.
Expenditure multiplier
The factor by which a change in autonomous spending (such as investment) is magnified into a larger change in equilibrium output. With a marginal propensity to consume (MPC) of 0.8, the simple multiplier is 1 / (1 - 0.8) = 5.
In simple terms, one dollar of new spending creates more than one dollar of new income because it gets re-spent.
Money demand (M^d)
The total quantity of money households and firms want to hold at a given interest rate and level of income. It rises with income (more transactions) and falls with the interest rate (higher opportunity cost of holding cash).
Money supply (M^s)
The total quantity of money in the economy, set by the Fed through open-market operations, the discount rate, and reserve requirements. Graphed as a vertical line because it does not depend on the interest rate.
Link 1 – Income to money demand. When aggregate output (Y) rises in the goods market, households and firms need more money for transactions, so money demand shifts right, pushing the interest rate up.
Link 2 – Interest rate to planned investment. When the interest rate changes in the money market, planned investment changes in the opposite direction. That change in investment shifts aggregate expenditure, changing equilibrium output back in the goods market.
Together these two links create a feedback loop: goods market → money market → goods market.
Suppose output rises (for any reason).
Higher income raises money demand.
With a fixed money supply, the interest rate rises.
Higher interest rate reduces planned investment.
Lower investment reduces aggregate expenditure and output.
The process partially offsets the original rise in output.
The same logic runs in reverse when output falls.
A downward-sloping curve means investment responds to the interest rate (the normal case).
A vertical investment schedule means investment is perfectly unresponsive to the interest rate. Changes in r have zero effect on I.
A horizontal investment schedule means investment is perfectly responsive. Even a tiny change in r causes an enormous swing in I.
The slope matters enormously for whether monetary and fiscal policy work, which Part 2 of these notes covers.
Interest rate drops from 7% to 5%: planned investment increases (move down the curve), aggregate expenditure rises, and equilibrium output rises.
Interest rate rises from 5% to 7%: planned investment decreases, aggregate expenditure falls, and equilibrium output falls.
The text gives a schedule where each 2-percentage-point drop in the interest rate adds $20 billion in planned investment:
Interest rate (%) | Planned investment ($ bn) |
|---|---|
6 | 200 |
8 | 180 |
10 | 160 |
12 | 140 |
14 | 120 |
16 | 100 |
To find the change in equilibrium output, multiply the change in investment by the expenditure multiplier.
Example: rate drops from 14% to 10%. Investment rises by $40 bn. With a multiplier of 5, equilibrium output rises by $200 bn.
Where M^d crosses the vertical M^s line, the interest rate is in equilibrium.
Above equilibrium (e.g. r = 8% when equilibrium is 7%): excess supply of money. People buy bonds, bond prices rise, and the interest rate falls back to equilibrium.
Below equilibrium: excess demand for money. People sell bonds, bond prices fall, and the interest rate rises.
Fed increases money supply: surplus of money at the old rate, so the interest rate falls.
Fed decreases money supply: shortage of money, interest rate rises.
GDP increases: money demand rises, shortage of money, interest rate rises.
GDP decreases: money demand falls, surplus of money, interest rate falls.
Changes in aggregate output shift the money-demand curve and therefore change the equilibrium interest rate. This means the interest rate is not determined exclusively in the money market; the goods market feeds into it.
Output falls → money demand falls → interest rate falls.
Output rises → money demand rises → interest rate rises.
Goods-market equilibrium: Y = C + I + G
Money-market equilibrium: M^d = M^s
Simple expenditure multiplier: Multiplier = 1 / (1 - MPC)
Change in equilibrium output from an interest-rate change: ΔY = Multiplier × ΔI
where ΔI is the change in planned investment read from the investment schedule.
Central banks cut interest rates during recessions precisely because lower rates are supposed to boost planned investment, raise aggregate expenditure, and lift output. The 2008 financial crisis and 2020 pandemic both saw the Fed slash rates to near zero for this reason. The feedback loop described here is the basic mechanism those policy decisions rely on.
"The interest rate is set only in the money market." It is determined there, but the goods market influences it by shifting money demand whenever output changes.
"A fall in the interest rate always raises output by the full multiplier amount." The feedback loop partially offsets the stimulus: higher output raises money demand, which pushes the rate back up somewhat.
"If the interest rate is above equilibrium, money demand must be too high." The opposite: at a rate above equilibrium, there is an excess supply of money (people want to hold less money than is available), so they buy bonds and the rate falls.
"Planned investment and the interest rate move in the same direction." They move in opposite directions along the investment schedule.
⚠️ You must know the two links (income → money demand; interest rate → planned investment) and be able to trace a chain of causation in either direction.
⚠️ Table-based questions are common: read the investment schedule, calculate ΔI, multiply by the multiplier, get ΔY.
⚠️ Know what a vertical vs. horizontal investment schedule implies (covered more in Part 2, but the definitions matter here).
⚠️ Distinguish goods-market equilibrium (Y = C + I + G) from money-market equilibrium (M^d = M^s). Exam questions test whether you can pick the right equation for the right market.
True or false: The interest rate affects the goods market through its impact on money demand. False. It affects the goods market through its impact on planned investment.
True or false: When aggregate output rises, money demand and the interest rate both rise. True.
True or false: Income is determined in the money market. False. Income (output) is determined in the goods market.
Fill in the blank: The two links between the goods market and the money market are ________ and ________. Income and the interest rate.
Q: If the interest rate drops from 14% to 8% using the Table 12.1 schedule, what happens to planned investment?
A: It increases by $60 billion (from $120 bn to $180 bn).
Q: Using Table 12.1, if the expenditure multiplier is 2 and the interest rate rises from 8% to 10%, what is the effect on equilibrium output?
A: Investment falls by $20 bn (180 → 160). Output change = 2 × (−$20 bn) = −$40 bn. Equilibrium output decreases by $40 billion.
Q: The Fed increases the money supply. What happens to the interest rate and why?
A: There is a surplus of money at the old interest rate. People use the extra money to buy bonds, pushing bond prices up and the interest rate down. The equilibrium interest rate falls.
Q: If GDP falls, what happens in the money market?
A: Money demand decreases (fewer transactions), creating a surplus of money at the old rate. The interest rate falls.
Q: Which equation represents equilibrium in the goods market: Y = M^s, M^d = M^s, or Y = C + I + G?
A: Y = C + I + G.
This section builds directly on the simple Keynesian cross / multiplier model from earlier chapters by adding the interest-rate channel. It sets up the crowding-out effect and policy-mix analysis covered in Chapter 12.2 (Part 2 of these notes). The IS-LM framework in the chapter appendix formalises everything here into two curves on one diagram.
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