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Chapter #15 ECN.doc

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Ryerson University
ECN 204
Christopher Gore

Chapter #15 - Earlier chapters covered: the long-run effects of fiscal policy on interest rates, investment, economic growth the long-run effects of monetary policy on the price level and inflation rate - This chapter focuses on the short-run effects of fiscal and monetary policy, which work through aggregate demand. Aggregate Demand - Recall, the AD curve slopes downward for three reasons: o The wealth effect The most important of o The interest-rate effect these effects for the o The exchange-rate effect economy 1. The wealth effect: A lower price level raises the real value of households’ money holdings, and higher real wealth stimulates consumer spending. 2. The interest-rate effect: A lower price level lowers the interest rate as people try to lend out their excess money holdings, and the lower interest rate stimulates investment spending. 3. The real exchange-rate effect: A lower price level reduces the real exchange rate. This depreciation makes Canadian-produced goods and services cheaper relative to foreign-produced goods and services. As a result, Canadian net exports rise. The Theory of Liquidity Preference - A simple theory of the interest rate (denoted r) - r adjusts to balance supply and demand for money - Money supply: assume fixed by central bank, does not depend on interest rate - Money demand reflects how much wealth people want to hold in liquid form. - For simplicity, suppose household wealth includes only two assets: o Money – liquid but pays no interest o Bonds – pay interest but not as liquid - A household’s “money demand” reflects its preference for liquidity. - The variables that influence money demand: Y, r, and P. Money Demand - Suppose real income (Y) rises. Other things equal, what happens to money demand? - If Y rises: o Households want to buy more g&s, so they need more money. o To get this money, they attempt to sell some of their bonds. - I.e., an increase in Y causes an increase in money demand, other things equal. Example: The determinants of money demand A. Suppose r rises. Other things equal, what happens to money demand? - r is the opportunity cost of holding money. - An increase in r reduces money demand: households attempt to buy bonds to take advantage of the higher interest rate. - Hence, an increase in r causes a decrease in money demand, other things equal. B. Suppose P rises. Other things equal, what happens to money demand? - If Y is unchanged, people will want to buy the same amount of g&s. - Since P is higher, they will need more money to do so. - Hence, an increase in P causes an increase in money demand, other things equal. How r Is Determined How the Interest-Rate Effect Works • Hence, this analysis of the interest rate effect can be summarized in three steps: o A higher price level raises money demand. o Higher money demand leads to a higher interest rate. o A higher interest rate reduces the quantity of goods and services demanded. Of course, the same logic works in reverse as well: A lower price level reduces money demand, which le
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