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

How Does Supply Of Money Affect Equilibrium Real Gdp Ratio
How Does Supply Of Money Affect Equilibrium Real Gdp Percentage

The quantity theory of money states that the supply of money times the velocity of money equals nominal GDP. According to the classical dichotomy, real variables, such as real GDP, consumption, investment, the real wage, and the real interest rate, are determined independently of nominal variables, such as. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S 0) to S 1, leading to an equilibrium (E 1) with a lower 6% interest rate and a quantity $14 billion in loaned funds.

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

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.

How Does Supply Of Money Affect Equilibrium Real Gdp Ratio

Learning Objectives

Explain and show how monetary policy impacts aggregate demand

Monetary Policy and Aggregate Demand

Monetary policy affects interest rates and the available quantity of loanable funds, which in turn affects several components of aggregate demand. Tight or contractionary monetary policy that leads to higher interest rates and a reduced quantity of loanable funds will reduce two components of aggregate demand. Business investment will decline because it is less attractive for firms to borrow money, and even firms that have money will notice that, with higher interest rates, it is relatively more attractive to put those funds in a financial investment than to make an investment in physical capital. In addition, higher interest rates will discourage consumer borrowing for big-ticket items like houses and cars. Conversely, loose or expansionary monetary policy that leads to lower interest rates and a higher quantity of loanable funds will tend to increase business investment and consumer borrowing for big-ticket items.

Watch It

Watch this video for a clear example of how changes in interest rates can impact investment, which in turn affect consumption, which can shift aggregate demand.

You can view the transcript for “Monetary Policy Graphs (1 of 2)- Macro 4.6” here (opens in new window).

If the economy is suffering a recession and high unemployment, with output below potential GDP, expansionary monetary policy can help the economy return to potential GDP. Figure 1(a) illustrates this situation. This example uses a short-run upward-sloping Keynesian aggregate supply curve (AS). The original equilibrium during a recession of Er occurs at an output level of 600. An expansionary monetary policy will reduce interest rates and stimulate investment and consumption spending, causing the original aggregate demand curve (AD₀) to shift right to AD₁, so that the new equilibrium (Ep) occurs at the potential GDP level of 700.

Figure 1. Expansionary or Contractionary Monetary Policy. (a) The economy is originally in a recession with the equilibrium output and price level shown at Er. Expansionary monetary policy will reduce interest rates and shift aggregate demand to the right from AD₀ to AD₁, leading to the new equilibrium (Ep) at the potential GDP level of output with a relatively small rise in the price level. (b) The economy is originally producing above the potential GDP level of output at the equilibrium Ei and is experiencing pressures for an inflationary rise in the price level. Contractionary monetary policy will shift aggregate demand to the left from AD₀ to AD₁, thus leading to a new equilibrium (Ep) at the potential GDP level of output.

Conversely, if an economy is producing at a quantity of output above its potential GDP, a contractionary monetary policy can reduce the inflationary pressures for a rising price level. In Figure 1(b), the original equilibrium (Ei) occurs at an output of 750, which is above potential GDP. A contractionary monetary policy will raise interest rates, discourage borrowing for investment and consumption spending, and cause the original demand curve (AD₀) to shift left to AD₁, so that the new equilibrium (Ep) occurs at the potential GDP level of 700.

These examples suggest that monetary policy should be countercyclical that is, it should act to counterbalance the business cycles of economic downturns and upswings. Monetary policy should be loosened when a recession has caused unemployment to increase and tightened when inflation threatens. Of course, countercyclical policy does pose a danger of overreaction. If loose monetary policy seeking to end a recession goes too far, it may push aggregate demand so far to the right that it triggers inflation. If tight monetary policy seeking to reduce inflation goes too far, it may push aggregate demand so far to the left that a recession begins. Figure 2(a) summarizes the chain of effects th