- 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
- 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.
- 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
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