21.1 How Monetary Policy Influences Aggregate Demand

21.1 a. The Theory of Liquidity Preference

The liquidity preference theory suggests that an investor demands a higher interest rate, or premium, on securities with long-term maturities, which carry greater risk, because all other factors being equal, investors prefer cash or other highly liquid holdings [1]. The most significant point about Keynes’s theory is that, at some very low interest rate, increases in the money supply will not encourage additional investment but instead will be absorbed by increases in people’s speculative balances. This will occur because the interest rate is too low to induce wealth holders to exchange their money for less liquid forms of wealth and because they expect interest rates to rise in the future.

Example: A three-year Treasury note might pay 2% interest, a 10-year treasury note might pay 4% interest and a 30-year treasury bond might pay 6% interest. In order for the investor to be willing to sacrifice more liquidity, he must be offered a higher rate of return in exchange for agreeing to have his cash tied up for a longer period of time [3].

^{Theory of Liquidity Preference [2]}

21.1 b. The Downward Slope of the Aggregate-Demand Curve

A higher price level raises money demand. Higher money demand leads to a higher interest rate. A higher interest rate reduces the quantity of goods and services demanded. The result of this analysis is a negative relationship between the price level and the quantity of goods and services demanded [4].

^{Downward Slope of the Aggregate-Demand Curve [5]}

21.1 c. Changes in the Money Supply

Monetary policy affects interest rates and the available quantity of loanable funds, which in turn affects several components of aggregate demand. Contractionary monetary policy that leads to higher interest rates and a reduced quantity of loanable funds will reduce two components of aggregate demand. Business investment will decline because it is less attractive for firms to borrow money, and even firms that have money will notice that, with higher interest rates, it is relatively more attractive to put those funds in a financial investment than to make an investment in physical capital. Conversely, expansionary monetary policy that leads to lower interest rates and a higher quantity of loanable funds will tend to increase business investment and consumer borrowing for big-ticket items [6].

^{Monetary Supply and Aggregate Supply [7]}

21.1 d. The Role of Interest-Rate Targets in Fed Policy

The federal funds rate is the interest rate at which banks borrow reserves from one another. A low federal funds rate implies expansionary monetary policy by the Federal Reserve; a low interest rate environment for businesses and consumers; and relatively high inflation. Low interest rate environments stimulate aggregate demand and employment [8]. Similarly a high interest rate make it costly to borrow money which increases the interest rates for general public. As a result, aggregate demand decreases as people demand low amount of loans at the higher interest rate.

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Example: Credit card interest rates are based on the federal funds rate. Any changes on the federal rate is passed directly onto consumers [9].

^{Fed Funds Rate and the Global Economy [10]}