The Price Level and Investment The Interest Rate Effect

As we discussed in Chapter 28, the price level is one determinant of the quantity of money demanded. The lower the price level, the less money households need to hold to buy the goods and services they want. When the price level falls, therefore, households try to reduce their holdings of money by lending some of it out. For instance, a household might use its excess money to buy interest-bearing bonds. Or it might deposit its excess money in an interest-bearing savings account, and the bank would use these funds to make more loans. In either case, as households try to convert some of their money into interest-bearing assets, they drive down interest rates. Lower interest rates, in turn, encourage borrowing by firms that want to invest in new plants and equipment and by households who want to invest in new housing. Thus, a lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded.

The Price Level and Net Exports: The Exchange-Rate Effect As we have just discussed, a lower price level in the United States lowers the U.S. interest rate. In response, some U.S. investors will seek higher returns by investing abroad. For instance, as the interest rate on U.S. government bonds falls, a mutual fund might sell U.S. government bonds in order to buy German government bonds. As the mutual fund tries to move assets overseas, it increases the supply of dollars in the market for foreign-currency exchange. The increased supply of dollars causes the dollar to depreciate relative to other currencies. Because each dollar buys fewer units of foreign currencies, foreign goods become more expensive relative to domestic goods. This change in the real exchange rate (the relative price of domestic and foreign goods) increases U.S. exports of goods and services and decreases U.S. imports of goods and services. Net exports, which equal exports minus imports, also increase. Thus, when a fall in the U.S. price level causes U.S. interest rates to fall, the real exchange rate depreciates, and this depreciation stimulates U.S. net exports and thereby increases the quantity of goods and services demanded.

Summary There are, therefore, three distinct but related reasons why a fall in the price level increases the quantity of goods and services demanded: (1) Consumers feel wealthier, which stimulates the demand for consumption goods. (2) Interest rates fall, which stimulates the demand for investment goods. (3) The exchange rate depreciates, which stimulates the demand for net exports. For all three reasons, the aggregate-demand curve slopes downward.

It is important to keep in mind that the aggregate-demand curve (like all demand curves) is drawn holding "other things equal." In particular, our three explanations of the downward-sloping aggregate-demand curve assume that the money supply is fixed. That is, we have been considering how a change in the price level affects the demand for goods and services, holding the amount of money in the economy constant. As we will see, a change in the quantity of money shifts the aggregate-demand curve. At this point, just keep in mind that the aggregate-demand curve is drawn for a given quantity of money.

First Time Home Buyers Guide

First Time Home Buyers Guide

If you are getting ready to purchase your first home or if you think you can't afford to purchase your first home, don't make another move until you have read this important information! Every year, Federal, State and Local government and community development programs help thousands of people obtain there first home.

Get My Free Ebook


Post a comment