Aug 15, 2014 Interest rates can directly affect inflation, and the Banks are known to increase or decrease the interest rates to either decrease or increase inflation. If the interest rate is reduced it is.
A decrease in real GDP causes a decrease in the money demand curve. A decrease in interest rates causes an increase in the money demand curve. An increase in the aggregate price level causes an increase in the money demand curve. Explanation: A demand curve is a graphical representation of the demand for money.

Real money demand, i.e., the liquidity function L(Y $, i $) is a downward sloping line in i $ reflecting the speculative demand for money. In other words, there is a negative relationship presumed to prevail between the interest rate and real money demand.

18.11 Effect of a Real GDP Increase (Economic Growth) on Interest Rates

Learning Objective

Learn how a change in real GDP affects the equilibrium interest rate.

Finally, let’s consider the effects of an increase in real gross domestic product (GDP). Such an increase represents economic growth. Thus the study of the effects of a real GDP increase is the same as asking how economic growth will affect interest rates.

GDP may increase for a variety of reasons, which are discussed in subsequent chapters. For now, we will imagine that GDP increases for some unspecified reason and consider the consequences of such a change in the money market.

Suppose the money market is originally in equilibrium at point A in Figure 18.5 'Effects of an Increase in Real GDP' with real money supply M^S/P_$ and interest rate i_$′. Suppose real GDP (Y_$) increases, ceteris paribus. Again, the ceteris paribus assumption means that we assume all other exogenous variables in the model remain fixed at their original levels. In this exercise, it means that the money supply (M^S) and the price level (P_$) remain fixed. An increase in GDP will raise the demand for money because people will need more money to make the transactions necessary to purchase the new GDP. In other words, real money demand rises due to the transactions demand effect. This increase is reflected in the rightward shift of the real money demand function from L(i_$, Y_$′) to L(i_$, Y_$″).

At the original interest rate, i_$′, real money demand has increased to level 2 along the horizontal axis while real money supply remains at level 1. This means that real money demand exceeds real money supply and the current interest rate is lower than the equilibrium rate. Adjustment to the higher interest rate will follow the “interest rate too low” equilibrium story.

The final equilibrium will occur at point B on the diagram. As the interest rate rises from i_$′ to i_$″, real money demand will have fallen from level 2 to level 1. Thus an increase in real GDP (i.e., economic growth) will cause an increase in average interest rates in an economy. In contrast, a decrease in real GDP (a recession) will cause a decrease in average interest rates in an economy.

Key Takeaway

Decrease In Real Money Demand Interest Rates Increase

An increase in real gross domestic product (i.e., economic growth), ceteris paribus, will cause an increase in average interest rates in an economy. In contrast, a decrease in real GDP (a recession), ceteris paribus, will cause a decrease in average interest rates in an economy.

Exercise

Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
1. The term used to describe a percentage increase in real GDP over a period of time.
2. Of increase, decrease, or stay the same, the effect on the equilibrium interest rate when real GDP decreases, ceteris paribus.
3. Of increase, decrease, or stay the same, the effect on the equilibrium interest rate when real GDP increases, ceteris paribus.

Interest Rate Decrease 2020

Economics 401 – Answers to Problems from Chapter 7

Review Questions
1. Money is the economist’s term for assets that can be used in making payments, such as cash and checking accounts. In everyday speech, people often use the term “money” to refer to their income or wealth, but in economics money means only those assets that are widely used and accepted as payment.
2. The three functions of money are (1) the medium of exchange function, which contributes to a better-functioning economy by allowing people to make trades at a lower cost in time and effort than in a barter economy; (2) the unit of account function, which provides a single, uniform measure of value; and (3) the store of value function, by which money is a way of holding wealth that has high liquidity and little risk.
3. The size of the nation’s money supply is determined by its central bank; in the United States, the central bank is the Federal Reserve System. If all money is in the form of currency, the money supply can be expanded if the central bank uses newly minted currency to buy financial assets from the public or directly from the government itself. To reduce the money supply, the central bank can sell financial assets to the public or the government, taking currency out of circulation.
4. The four characteristics of assets that are most important to wealth holders are (1) expected return, (2) risk, (3) liquidity; and (4) time to maturity. Money has a low expected return compared to other assets, low risk since it always maintains its nominal value, is the most liquid of all assets, and has the lowest (zero) time to maturity.
5. The expectations theory of the term structure of interest rates is the idea that investors compare bonds with different times to maturity and choose the ones that yield the highest return. In equilibrium, the theory implies that the expected rate of return on an N-year bond should equal the average of the expected rates of return on one-year bonds during the current year and the N–1 succeeding years.
The expectations theory is not sufficient because on average, long-term interest rates exceed short-term interest rates, in violation of the theory’s implications. To form a more accurate theory, a risk premium must be added to the analysis.
6. The macroeconomic variables that have the greatest impact on money demand are the price level, real income, and the nominal interest rate on other assets. The higher the price level, the higher the demand for money, since more units of money are needed to carry out transactions. The higher the level of real income, the higher the need for liquidity, and so the higher is money demand. When the nominal interest rate on other assets is high, money demand is low, because the opportunity cost of holding money (that is, the interest you forgo on other assets because you are holding money instead) is high.
7. Velocity is a measure of how often money “turns over” in a period. It is equal to nominal GDP divided by the nominal money supply. The quantity theory of money assumes that velocity is constant, which implies that real money demand is proportional to real income and is unaffected by the real interest rate.
8. Equilibrium in the asset market is described by the condition that real money supply equals real money demand because when supply equals demand for money, demand must also equal supply for nonmonetary assets. The aggregation assumption that is needed for this is that we can lump all wealth into two categories: (1) money and (2) nonmonetary assets.
9. In equilibrium, the price level is proportional to the nominal money supply; in particular it equals the nominal money supply divided by real money demand. Similarly, the inflation rate is equal to the growth rate of the nominal money supply minus the growth rate of real money demand.
10. Factors that could increase the public’s expected rate of inflation include a rise in money growth or a decline in income growth. With no effect on the real interest rate, the increase in the expected inflation rate would increase the nominal interest rate.
Numerical Problems
1. For a two-year bond, according to the expectations theory, the interest ra