Output and prices in a world without the real balance effect

Abstract

As has been shown in Chapter 4, one can conclude that monetary policy in the euro-area works primarily through the interest rate channel on aggregate investment. By changing the short-term interest rate, the ECB changes yields on other financial instruments, which in turn change the interest rate that firms have to pay for financing their investment. Depending on the demand conditions they face, they will decide which of their potential investment projects looks sufficiently promising and will conduct the investments necessary for these projects. The lower the interest rates, the more projects promise profit, given certain fixed demand conditions, thus the higher the aggregate investment.