MGT411 - Money & Banking - Lecture Handout 40

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  • To shift the focus to inflation, we need to look at changes in the price level.
  • Suppose that inflation exceeds money growth (with velocity held constant). Real money balances will fall and so will aggregate demand

The Aggregate Demand Curve

  • Because real money balances fall at higher levels of inflation, resulting in a lower level of aggregate demand, the aggregate demand curve is downward sloping.
  • Changes in the interest rate also provide a mechanism for aggregate demand to slope down

Monetary Policy and the Real Interest Rate

  • Central bankers control short-term nominal interest rates by controlling the market for reserves.
  • But the economic decisions of households and firms depend on the real interest rate;
  • To alter the course of the economy, central banks must influence the real interest rate as well
  • In the short run, because inflation is slow to respond, when monetary policymakers change the nominal interest rate they change the real interest rate.
  • The real interest rate, then, is the lever through which monetary policymakers influence the real economy.
  • In changing real interest rates, they influence aggregate demand.

Aggregate Demand and the Real Interest Rate

  • Aggregate demand is divided into four components:
  • Consumption,
  • Investment,
  • Government purchases,
  • Net exports
  • Aggregate Govt.’s Net Demand = Consumption + Investment + Purchases + Exports
    Yad = C + I + G + NX
  • It is helpful to think of aggregate demand as having two parts, one that is sensitive to real interest rate changes and one that is not
  • Investment is the most important of the components of aggregate demand that are sensitive to changes in the real interest rate.
  • An investment can be profitable only if its internal rate of return exceeds the cost of borrowing
  • Consumption and net exports also respond to the real interest rate;
  • Consumption decisions often rely on borrowing, and the alternative to consumption is saving (higher rates mean more saving).
  • As for net exports, when the real interest rate in a country rises, her financial assets become attractive to foreigners, causing local currency to appreciate, which in turn means more imports and fewer exports (lower net exports)
  • While changes in real interest rate may have an impact on the government’s budget by raising the cost of borrowing, the effect is likely to be small and ignorable.
  • Thus, considering consumption, investment, and net exports, an increase in the real interest rate reduces aggregate demand (the effect on the 4th component, government spending, is small enough to be ignored).
Impact of rise in the Real interest rate on Components of Aggregate Demand
Components of
Aggregate Demand
Effect of a rise in the real interest
Impact on component
of Aggregate Demand
Consumption (C) Reward to saving rises Consumption falls
Investment (I) Cost of financing rises Investment falls
Net Exports (NX) Demand for domestic assets rises,
causing a currency appreciation, raising
the price of exports and reducing the
cost of imports
Exports fall; imports rises;
net exports fall
Aggregate Demand (Yad) C, I and NX all fall Aggregate demand falls

The Long-Run Real Interest Rate

  • There must be some level of the real interest rate at which aggregate demand equals potential output; this is the long-run real interest rate.
  • The long-run real interest rate equates aggregate demand with potential output.
  • The rate will change if a component of aggregate demand that is not sensitive to the real interest rate goes up (or down) or if potential output changes.
  • For example, an increase in government purchases (all else held constant) will raise aggregate demand at every level of the real interest rate.
  • To remain in equilibrium, one of the interest-sensitive components of aggregate demand must fall, and for that to happen, the long-run real interest rate must rise.
  • The same would be true for increases in other components of aggregate demand that are not interest sensitive.
  • A change in potential output has an inverse effect on the long-run real interest rate;
  • When potential output rises, aggregate demand must rise with it, which requires a decrease in the real interest rate

Inflation, the Real Interest Rate, and the Monetary Policy Reaction Curve

  • Policymakers set their short-run nominal interest rate targets in response to economic conditions in general and inflation in particular.
  • When current inflation is high or current output is running above potential output, central bankers will raise nominal interest rates; when current inflation is low or current output is well below potential, they will lower interest rates
  • While they state their policies in terms of nominal rates they do so knowing that changes in the nominal interest rate will eventually translate into changes in the real interest rate, and it is those changes that influence the economic decisions of firms and households
  • Experts agree that any (coherent) monetary policy can be written as an inflation target plus a response to supply shocks

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