.How MONETARY POLICY INFLUENCES AGGREGATE DEMAND
The aggregate-demand curve shows the total quantity of goods and services demanded in the economy for any price level. The preceding chapter discussed three reasons the aggregate-demand curve slopes
• The wealth effect: A lower price level raises the real value of households’ money holdings, which are part of their wealth. Higher real wealth stimulates consumer spending and thus increases the quantity of goods and services demanded.
• The interest-rate effect: A lower price level reduces the amount of money people want to hold. As
people try to lend out their excess money holdings, the interest rate falls. The lower interest rate stimulates investment spending and thus increases the quantity of goods and services demanded.
• The exchange-rate effect: When a lower price level reduces the interest rate, investors move some of their funds overseas in search of higher returns. This movement of funds causes the real value of the domestic currency to fall in the market for foreign-currency exchange. Domestic goods become less expensive relative to foreign goods. This change in the real exchange rate stimulates spending on net exports and thus increases the quantity of goods and services demanded.
These three effects occur simultaneously to increase the quantity of goods and services demanded when the price level falls and to decrease it when the price level rises. Although all three effects work together to explain the downward slope of the aggregate-demand curve, they are not of equal importance. Because money holdings are a small part of household wealth, the wealth effect is the least important of the three. In addition, because exports and imports represent only a small fraction of U.S. GDp, the exchange-rate effect is not large for the U.S. economy. (This effect is more important for smaller countries, which typically export and import a higher fraction of their GDP.) For’ the Us. economy, the most important reason for the downward slope of the aggregate-demand is the interest-rate effect. To better understand aggregate demand, we now examine the short-run determination 0;interest rates in more’ detail. Here we develop the theory of liquidity preference. This theory of interest rate determination will help explain the downward slope of the .aggregate-demand curve, as well as how monetary and fiscal policy can shift this curve. By shedding new light on aggregate demand, the theory of liquidity preference expands our understanding of what causes short-run economic fluctuations and what policy makers can potentially do about them.