1. Reconciling the Models
Liquidity Preference Model of the Interest Rate
AD-AS Model
Loanable Funds Model
of the Interest Rate
LRAS
SRAS2
MS1
MS2
SRAS1 S1
Agg. Price Level (PL)
Interest Rate (r)
Interest Rate (r)
PL3 S2
PL2 r r
Here’s the story line…
In the short-run: ↑MS , ↓r, ↑I, ↑Real GDP, ↑S
In the long-run: ↑MS causes nominal wages to ↑; therefore ↓SRAS , the resulting ↑PL, ↑MD, which ↑r
The resulting ↓ in Real GDP, ↓S, which ↑r in the loanable funds market.
PL1 r1
MD2 r1
MD1
AD2 D
AD1 M1 M2 Q1 Q2 Y1 Y2
Quantity of money
Quantity of loanable funds
Real GDP (Y)