[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

When we discuss interest rates and monetary policy, it is natural to
start with the capital market. We have already seen, in Chapter 24,
how the real rate of interest balances saving and investment when the
economy is at full employment. When the economy is not at full employment,
saving and investment must still balance to ensure that the capital
market is in equilibrium. Figure 31.1 shows capital market equilibria
for two different levels of output. When the economy is producing at
full employment, as we assumed in Part Six, the saving and investment
schedules are given by S f and I f . (For the sake of simplicity, we have
assumed saving does not vary with the real interest rate—that is why
it is drawn as a vertical line.) The equilibrium real rate of interest is
r 0 . If the economy’s output is at less than its full-employment level,
household income will be lower, and households will save less at each
value of the real interest rate. This outcome is shown by the saving
schedule S 1 , to the left of S f . The saving schedule shifts left because
the marginal propensity to consume is less than one—a one-dollar
decline in income reduces consumption by less than a dollar, which
means that saving is also reduced. If there is no change in the investment
schedule, the capital market will again be in equilibrium at
an income level below full employment when the real interest rate
rises to r 1 .
However, investment will not remain the same if GDP drops. When
output falls and the economy enters a recession, the investment schedule
will also be affected. Declines in production lead to higher unemployment
of labor and lower utilization of plant and equipment. The
drop reduces the need for new investment, and firms are less likely to
invest when the business outlook is bleak. The leftward shift in the
investment schedule is depicted by the investment schedule I 1 in Figure
31.1. In this case, the equilibrium real interest rate is r 2 . Depending on
the relative shifts of the saving and investment schedules, the new
equilibrium real interest rate may be greater or less than r 0 .
When the economy is at full employment, equilibrium in the capital market determines
the full-employment real interest rate. But what determines output and the
real interest rate at less than full employment? To answer this question, we turn
now to the connection among inflation, spending, and monetary policy.
REAL INTEREST RATE (p)
r 1
r 2
r 0
Figure 31.1
Y 1
S 1
E 1
E 0
S f
Investment
schedules
CAPITAL MARKET EQUILIBRIUM AT
DIFFERENT INCOME AND INTEREST RATES
A fall in income from Y f to Y 1 will shift the savings line
to the left, from S f to S 1 . If the investment schedule
remains unchanged, capital market equilibrium will occur
at a higher real interest rate, r 1 , and lower level of real
income. A decline in output, however, is likely to shift
the investment schedule to the left as firms reduce
planned investment spending at each value of the real
rate of interest. If the new investment schedule is I 1 , the
equilibrium real rate of interest is r 2 . Depending on the
magnitudes of the shifts, the final equilibrium real interest
rate could be higher or lower than r 0 .
Y
f
I 1
I f
The Aggregate Demand–Inflation
Curve
In Chapter 29, we listed the effect of inflation on aggregate expenditures as the
fourth of the key concepts for understanding short-run fluctuations of the economy.
Now this relationship must be explored in more detail. Because monetary policy
plays an important role in determining how changes in inflation affect aggregate
expenditures, we need to focus on Fed policy.
THE AGGREGATE DEMAND–INFLATION CURVE ∂ 691