KRUGMAN_WELLS_MACRO_CHAPTER14

We promised to explain how this is consistent with

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Unformatted text preview: d the liquidity preference model of the interest rate. In this model, the equilibrium interest rate is the rate at which the quantity of money demanded equals the quantity of money supplied. We promised to explain how this is consistent with the loanable funds model of the interest rate we developed in Chapter 9. In this second model, the equilibrium interest rate matches the quantity of loanable funds supplied by savers with the quantity of loanable funds demanded for investment spending. We will now take the first of two steps toward providing that explanation, focusing on what happens in the short run. As we have just discussed, a fall in the interest rate leads to a rise in investment spending, I, which then leads to a rise in both real GDP and consumer spending, C. The rise in real GDP doesn’t lead only to a rise in consumer spending, however. As we noted, it also leads to a rise in savings: at each stage of the multiplier process, part of the increase in disposable income is saved. How much do savings rise? In Chapter 9 we introduced the savings–investment spending identity: total savings in the economy is always equal to investment spending. This tells us that when a fall in the interest rate leads to higher investment spending, the resulting increase in real GDP generates exactly enough additional savings to match the rise in investment spending. To put it another way, the quantity of savings supplied rises exactly enough to match the quantity of savings demanded. Figure 14-11 on page 358 shows that our two models of the interest rate are reconciled by the link among changes in the interest rate, changes in real GDP, and changes in savings. Panel (a) represents the liquidity preference model of the interest M O N E TA R Y P O L I C Y 357 358 PA R T 5 Figure S H O R T- R U N E C O N O M I C F L U C T U AT I O N S 14-11 UNCORRECTED Preliminary Edition The Short-Run Determination of the Interest Rate (a) The Liquidity Preference Model of the Interest Rate Interest rate, r Interest rate, r MS1 r1 (b) The Loanable Funds Model of the Interest Rate MS2 S1 E1 r1 E1 E2 E2 r2 S2 r2 MD D M1 M2 Nominal quantity of money, M Panel (a) shows the liquidity preference model of the interest rate: the equilibrium interest rate matches the money supply to the quantity of money demanded. In the short run, the interest rate is determined in the money market, where an increase in the money supply from M1 to M2 pushes the equilibrium interest rate down from r1 to r2. Panel (b) shows the market for loanable funds model of the interest rate. The fall in the interest rate in Quantity of loanable funds the money market leads, through the multiplier effect, to an increase in GDP and savings; to a rightward shift of the supply curve of loanable funds, from S1 to S2,; and to a fall in the interest rate, from r1 to r2. As a result, the new equilibrium interest rate in the loanable funds market matches the new equilibrium interest rate in the money market at E2. rate. MS1 and MD are the initial supply and demand curves for money. According to the liquidity preference m...
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This note was uploaded on 09/09/2009 for the course ECON 701 taught by Professor Charlie during the Spring '09 term at École Normale Supérieure.

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