If real money balances enter the IS-LM model both through the theory of liquidity preference and the Pigou effect, then a fall in the price level will result in higher income and:
A) higher interest rates.
B) lower interest rates.
C) no change in interest rates.
D) either higher, lower, or unchanging interest rates.

Question

Quizplus · Accepted Answer

In the IS-LM model, a fall in the price level increases real money balances. Through the liquidity preference theory, this would typically lower interest rates as people hold more money relative to bonds. However, the Pigou effect, which suggests that a lower price level increases the real wealth of individuals leading to higher consumption and potentially higher demand for money, could offset or alter this impact. Thus, the overall effect on interest rates could vary, leading to higher, lower, or unchanged rates depending on the relative strengths of these effects.

If Real Money Balances Enter the IS-LM Model Both Through