This chapter focuses on the government tools that influence the aggregate-demand curve in the short-run; that is monetary policy and fiscal policy. We first examine the short-run market through Keyne's theory of liquidity preference that states the interest rate adjusts to bring money supply and money demand into balance. Both nominal and real interest rates are affected and move in the same direction. (Real+nominal=short-run, nominal=long-run). Money supply in this market is controlled through the Fed Reserve and so is fixed/ vertical. Money demand is determined in large by the interest rate, where an increased interest rate raises the cost of holding money, and as a result, reduces the quantity of money demanded. The market is constantly trying to maintain an equilibrium interest rate.
If the interest rate is above the equilibrium level, the quantity of money that people want to hold is less than the quantity supplied. Those people buy interest-bearing assets and banks/loaners respond with lower interest rates. The reverse of this is true for when interest rates are below the equilibrium level.
There is a negative relationship between price level and quantity demanded. When price level increases, the quantity of money demanded increases at any given interest rate, thus shifting the MD curve to the right. This, however, only translates to a leftward movement along the aggregate-demand curve because it is only for a specific price level. This reduces quantity of output.
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