Keynes effect

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The Keynes effect is a term used in economics to describe a situation where a change in interest rates affects expenditure more than it affects savings.

As prices fall, a given nominal amount of money will become a larger real amount. As a result the interest rate will fall and investment demanded rise.

This means that insufficient demand in the product market cannot exist forever.

There are two cases in which the Keynes effect does not occur: in the liquidity trap (when the LM curve is horizontal), or when expenditure is inelastic with respect to interest rates (when the IS curve is vertical). The Patinkin-Pigou real balance effect shows that due to wealth effects of changes in price level, insufficient demand cannot persist even in the two cases above.