Interest Rate Effect
What is Interest Rate Effect?
The interest rate effect is the change in investment that results from a change in the interest rate due to a change in the price level.
When the price level rises, people need more money to buy goods and services. This increases the demand for money, which leads to an increase in the interest rate. Higher interest rates discourage borrowing and investment, leading to a decrease in aggregate demand. Conversely, when the price level falls, the interest rate decreases, leading to an increase in investment and aggregate demand.
Interest Rate Effect: a worked example
Hold the money supply fixed at $600 billion. The price level rises from 100 to 104, an increase of 4 percent, so households and firms need roughly 4 percent more money to carry out the same real transactions, and money demand climbs to about $624 billion at the old interest rate. With the money supply unchanged, that shortage bids the nominal interest rate up from 3 percent to 5 percent. Firms then read their investment demand schedule: they planned $260 billion of investment at 3 percent but only $245 billion at 5 percent, a fall of $15 billion. Interest-sensitive consumer purchases such as cars and homes drop another $5 billion. Autonomous spending is down $20 billion, and with an MPC of 0.75 the multiplier of 4 carries the quantity of real output demanded from $900 billion down to $820 billion.
The mistake students make with interest rate effect
On the money market diagram, a rising price level sends many students to the money supply curve. The central bank sets the money supply, so that curve stays put; the price level works on money demand, because more dollars are needed to settle the same real transactions. Shifting the wrong curve can still drive the interest rate up, which hides the error behind a correct-looking answer. The second slip is stopping the chain at investment. Interest-sensitive consumer purchases fall too, so the drop in real output demanded exceeds the change in investment alone.
Interest Rate Effect questions
Is the interest rate effect the same as monetary policy?
No. Monetary policy is a deliberate change in the money supply by the central bank, and it shifts the aggregate demand curve. The interest rate effect begins with a change in the price level, which changes how much money people need for transactions and therefore the interest rate. One shifts the curve, the other explains why the curve slopes downward in the first place.
How does the interest rate effect make aggregate demand slope downward?
A higher price level forces households and firms to hold more money to make the same real purchases. With the money supply fixed, that extra demand for money pushes the nominal interest rate up. Borrowing costs more, planned investment falls, and the rounds of lost income that follow shrink the quantity of real output demanded at that higher price level. Reverse the price level change and the chain runs the other way, which traces a downward-sloping curve.
What is the difference between the interest rate effect and the wealth effect?
Both explain the downward slope of aggregate demand, through different channels. The wealth effect works on purchasing power: a higher price level makes the money households already hold worth less in real terms, so consumption falls. The interest rate effect works through borrowing costs: a higher price level raises money demand and the interest rate, so investment falls. One hits consumption directly, the other hits investment.
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