Question

With respect to the interest rate, a. what is the liquidity effect? b. what is the price-level effect? c. what is the expectations effect?

Short answer

a. The liquidity effect postulates that lowering interest rates increases economy's liquidity by inducing borrowing, whereas raising rates reduces liquidity by discouraging borrowing. b. The price-level effect suggests that increasing interest rates can cause price levels to fall by curbing demand, while decreasing interest rates can cause price levels to rise by stimulating demand. c. The expectations effect argues that expected changes in future interest rates can influence current long-term interest rates.

Step-by-step solution

Liquidity effect

The liquidity effect concerns how a change in interest rates, typically initiated by a central bank from a monetary policy perspective, impacts the liquidity of an economy. If the central bank lowers interest rates, people are more likely to borrow and spend money, thus increasing liquidity. Conversely, if the central bank raises interest rates, people are less likely to borrow and more likely to save, thus reducing liquidity in the economy.

Price-level effect

The price-level effect refers to how changing interest rates might impact the overall price level in an economy. If interest rates are increased by the central bank, borrowing becomes more expensive and people tend to save more and spending less. This decreased demand for goods and services can lead to a fall in price levels as suppliers aim to stimulate demand. Conversely, if interest rates are decreased, borrowing becomes cheaper. Hence, spending may increase which might lead to an increase in price levels (inflation) as increased demand outpaces supply.

Expectations effect

The expectations effect concerns the impact of expected future interest rates on current long-term interest rates. If it is expected that the central bank will raise interest rates in the future, then this will cause an immediate increase in long-term interest rates in the present. This occurs as lenders demand higher interest rates on loans to compensate for the expected rise in future rates. Conversely, if it is expected that rates will drop in the future, long-term rates will decrease now.