Financial institutions are able to hedge another type of risk – liquidity risk. Liquidity transformation – the fourth function in my list – helps control liquidity risk for the aggregate economy. Individuals generally express a high preference for liquidity in anticipation of uncertain future disbursements.
As the spending behavior of businesses and households will be greatly influenced by real interest rates, if real rates can be lowered, both private consumption and business investment will be stimulated and the level of economic activity will heighten. As a result, supply and demand balances will tighten in goods and services markets, as well as the labor market, and prices will rise accordingly.