Finance and the Economy · Seminar 9 · Government economic policy
The central bank fixes the supply of money, so MS is vertical. Money demand slopes down: at a lower interest rate people hold more cash. The interest rate balances the two. Open-market purchases or lower reserve requirements shift MS right; a stronger preference for liquidity shifts MD right. Questions 5 and 6, from Business Economics (Mankiw, Taylor & Ashwin, ch. 22).
Interest rate
Money supply
Effect on aggregate demand
The transmission. Liquidity preference says the interest rate is the price that balances money supply and money demand. A lower rate makes borrowing cheaper, lifting consumption and investment and shifting AD right; a higher rate does the reverse. That is the channel through which monetary policy reaches the real economy.
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