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

Learning Objective

Money Demand Increases As Real Gdp Grows More Rapidly Than Population

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

That relationship suggests that money is a normal good: as income increases, people demand more money at each interest rate, and as income falls, they demand less. An increase in real GDP increases incomes throughout the economy. The demand for money in the economy is therefore likely to be greater when real GDP is greater. An increase in real gdp tends to increase the real per capita income of people assuming that the increase in wealth is distributed fairly. The increase in gdp leads to an increase in income which in turn leads to an increase in the demand of real money balances by people. An increase in real GDP the demand for money and changes in financial technology. The quantity of money grows at a rate of 16 percent a year, potential.

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.

In the 1930s, Keynes also challenged the quantity theory of money, saying that increases in the money supply actually lead to a decrease in the velocity of money in circulation and that real.

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_$″).

Money Demand Increases As Real Gdp Grows As A

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.

Money Demand Increases As Real Gdp Grows At 7 Percent

Exercise

Money Demand Increases As Real Gdp Grows More Slowly Than Potential Gdp

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.