Chapter Summary

In this chapter we have extended the Keynesian model to take account of the monetary system, interest, investment, and the impact of interest on investment. As we did so we noted that

• Interest is a key cost of investment. Indeed
• The profitability of investment can be expressed by the "internal rate of return," that is, the highest interest rate at which the investment would break even. Therefore
• The higher the interest rate, the less investment can be profitably undertaken.
• This defines an inverse relationship between interest and investment, the marginal efficiency of investment.
• The interest rate in turn depends on the supply of money.
• For these purposes, both the interest rate and the supply of money are adjusted for inflation -- real interest and real money balances.
• Therefore, an increase in the price level will reduce the real value of a given nominal money supply, putting up interest rates, and therefore putting down investment and production.
• This is the basis for an inverse aggregate demand relationship.

We began with a theory of the inverse aggregate demand relationship based on reasoning by analogy. Reasoning by analogy can be creative, but we can put more confidence on a theory based on a chain of cause-and-effect relationships, even if the chain is pretty long. We now have that chain -- and we can check each of the links against the evidence, and check out the performance of the theory as a whole.

But first, we need to complement it with a theory of aggregate supply.

Next Chapter: Aggregate Supply

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