Consider an economy where the demand for real money balances is interest-elastic and the demand for investment is interest-inelastic. A change in the money supply will result in a relatively: a) small change in the rate of interest and the level of investment. b) large change in the rate of interest and the level of investment. c) small change in the rate of interest and a relatively large change in the level of investment. d) large change in the rate of interest and a relatively small change in the level of investment. Can anyone please explain the theory behind it
This is all about the strengths of the transmission mechanisms covered in Module 18. The transmission mechanism is: increase in money supply leads to a decrease in interest rates, which leads to an increase in (consumption and) investment. But how strong are these links? (1) the money - interest rate link. You know that if there is an increase in the supply of money the interest rate will fall, but how much it falls depends on how elastic the demand for money is with respect to interest rates - the more elastic, the less the interest rate will have to fall (because it only needs a tiny drop in interest rates to encourage people to hold more money and sell their bonds). You can draw the diagram to show this. (2) the interest rate - investment link. You know that when interest rates decrease, this increases investment, but how much depends on how elastic the demand for investment is with respect to interest rates - the more elastic, the greater the impact on investment.
Freddie, For point (1) you wrote "it only needs a tiny drop in interest rates to encourage people to hold more money and sell their bonds" For point (2) you wrote "when interest rates decrease, this increases investment" Don't these 2 points contradict each other? What happens to investment when interest rates decrease? Thanks
Investment, in an economic sense, means buying / creating new projects and capital goods, which are actually used to produce other goods and services on an ongoing basis. Buying bonds does not constitute investment in the economic sense, as it merely means buying the right to receive an existing series of cashflows generated by an existing underlying set of assets or projects. In an economic sense, it is savings. In general, investment in new projects, ie investment in an the economic sense, will increase when interest rates, ie the cost of borrowing to fund such projects, falls.
