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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 1411 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 1411 UNCORRECTED Preliminary Edition The ShortRun 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.
 Spring '09
 Charlie
 Monetary Policy

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