Chapter 8
Financial Markets and Aggregate Demand
Spending depends on the interest rate because of the sensitivity of investment and net exports to the interest
rate.
8.1 INVESTMENT AND THE INTEREST RATES
Financial Variables
– interest rates and the supply of money
The Investment Demand Function
*investment depends negatively on the interest rate
demand for investment goods is low when interest rates are high and vise versa
*relationship for investment demand
Investment function
– Relation between investment and the interest rate
I = e – dR
I = Investment
R = Interest Rate
e and d are constants
 investment demand is equal to constant e minus another constant d times the
interest rate
 It is a downwardsloping line
The Meaning and Interpretation of
R
•
R
means the real interest rate
The real interest is the nominal interest rate minus the expected rate of inflation
 The real rate of interest measures how much you earn on your deposit after taking
account of the fact that inflation increases the price of goods that you might purchase
in a year
The Investment Function
1. Investment demand is negatively related to the interest rate.
When funds are more expensive,
less investment takes place.
The investment function describes this negative relationship.
2. The interest rate R in the investment function is an average of the many interest rates we
observe at banks and in the financial markets.
8.2 NET EXPORTS AND THE INTEREST RATE
*Net exports depend negatively on the interest rate
* net exports (exports minus imports) fall when the U.S. interest rate rises, because the exchange
rate rises.
X = g – mY  NR
The new coefficient n measures the decrease in net exports that occurs when the interest rate rises
by 1 % point
8.3 THE DEMAND FOR AND SUPPLY OF MONEY
Money
– total amount of currency and checking deposits.
Money is used synonymously with the
money supply
The Demand for Money
Three basic propositions about the demand for money are imports in macroeconomics:
1. People want to hold less money when the interest rate is high and, conversely, hold
more money when the interest rate is low.
* negative relationship between the demand for money and the interest rate R.
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 Spring '07
 GREENLAW
 Macroeconomics, Inflation, Interest Rates, Monetary Policy, Supply And Demand, price level

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