Finally, evaluate the consequences of a rise in real gross domestic product (GDP) (GDP). Such an increase indicates that the economy is growing. As a result, looking at the implications of a rise in real GDP is the same as looking at how interest rates will change as a result of economic expansion.
GDP may rise for a variety of causes, which will be examined in more detail in the next chapters. For the time being, we’ll assume that GDP rises for no apparent reason and explore the implications of such a development in the money market.
Assume the money market is initially in equilibrium with real money supply MS/P$ and interest rate i$ at point A in Figure 18.5 “Effects of an Increase in Real GDP.” Assume, for the sake of argument, that real GDP (Y$) rises. The ceteris paribus assumption states that all other exogenous variables in the model will remain constant at their initial values. It means that the money supply (MS) and the price level (P$) are both fixed in this exercise. People will need more money to make the transactions required to purchase the new GDP, hence a growth in GDP will enhance money demand. In other words, the transactions demand effect raises real money demand. The rightward change of the real money demand function from L(i$, Y$) to L(i$, Y$) reflects this rise.
When real GDP rises, what happens to money?
The value of money in circulation rises in general when the GDP growth rate shows increased economic productivity. This is due to the fact that each unit of currency can be exchanged for more value goods and services in the future.
Is it true that as real GDP rises, the demand for money falls?
When real GDP rises, more products and services are available for purchase. To buy them, more money will be required. A fall in real GDP, on the other hand, will result in a decrease in the money demand curve.
What happens when the demand for real money rises?
Shift in the Demand Curve: The graph depicts both the supply and demand curves, with money quantity (Q) on the x-axis and money price (interest rates) on the y-axis (P). The price of money (interest rates) rises in tandem with the quantity of money demanded, causing the demand curve to rise and move to the right. The curve would shift to the left if demand fell.
What causes real GDP to rise?
A rise in aggregate demand drives economic growth in the short run (AD). If the economy has spare capacity, an increase in AD will result in a higher level of real GDP.
Factors which affect AD
- Lower interest rates – Lower interest rates lower borrowing costs, which encourages consumers to spend and businesses to invest. Lower interest rates cut mortgage payments, increasing consumers’ discretionary income.
- Wages have been raised. Increased real wages enhance disposable income, which encourages consumers to spend.
- Greater government expenditure (G), such as government investments in new roads or increased spending on welfare payments, both of which enhance disposable income.
- Devaluation. A decrease in the value of the currency rate (for example, the Pound Sterling) lowers the cost of exports and increases the volume of exports (X). Imports become more expensive as a result of depreciation, lowering the quantity of imports and making domestic goods more appealing.
- Confidence. Households with higher consumer confidence are more likely to spend, either by depleting their savings or taking out more personal credit. It encourages spending by allowing increased spending (C) (C).
- Reduced taxation. Consumers’ disposable income will increase as a result of lower income taxes, which will lead to increased expenditure (C).
- House prices are increasing. A rise in housing prices results in a positive wealth effect. Homeowners who see their property value rise will be more willing to spend (remortgaging house if necessary)
- Financial stability is important. Firms will be more eager to invest if there is financial stability and banks are willing to lend, and investment will enhance aggregate demand.
Long-term economic growth
This necessitates an increase in both AD and long-run aggregate supply (productive capacity).
- Capital increase. Investment in new manufacturing or infrastructure, such as roads and telephones, are examples.
- Increased labor productivity as a result of improved education and training, as well as enhanced technology.
- New raw materials are being discovered. Finding oil reserves, for example, will boost national output.
- Microcomputers and the internet, for example, have both led to higher economic growth through improving capital and labor productivity. New technology, such as artificial intelligence (AI), which allows robots to take the place of human workers, may be the source of future economic growth.
Other factors affecting economic growth
- Stability in the economy and politics. Stability is vital for convincing businesses that investing in capacity expansion is a sensible decision. When there is a surge in uncertainty, confidence tends to diminish, which can cause businesses to postpone investment.
- Inflation is low. Low inflation creates a favorable environment for business investment. Volatility is exacerbated by high inflation.
Periods of economic growth in UK
The United Kingdom saw substantial economic expansion in the 1980s, owing to a number of factors.
- Reduced income taxes increase disposable income, which leads to increased expenditure and, in turn, stimulates corporate investment.
- House prices rose, resulting in a positive wealth effect, equity withdrawal, and increased consumer spending.
What happens to unemployment when real GDP rises?
Employment will rise as long as growth in real gross domestic product (GDP) outpaces growth in labor productivity. The unemployment rate will fall if employment growth outpaces labor force growth.
What happens if the real GDP falls?
When GDP falls, the economy shrinks, which is terrible news for businesses and people. A recession is defined as a drop in GDP for two quarters in a row, which can result in pay freezes and job losses.
What causes GDP to rise and fall?
The external balance of trade is the most essential of all the components that make up a country’s GDP. When the total value of products and services sold by local producers to foreign countries surpasses the total value of foreign goods and services purchased by domestic consumers, a country’s GDP rises. A country is said to have a trade surplus when this happens.
What causes a drop in real GDP?
Shifts in demand, rising interest rates, government expenditure cuts, and other factors can cause a country’s real GDP to fall. It’s critical for you to understand how this figure changes over time as a business owner so you can alter your sales methods accordingly.
What is the demand for real money?
The demand for money in monetary economics refers to the desire to hold financial assets in the form of money, such as cash or bank deposits rather than investments. It can relate to the demand for money in a narrow sense (directly spendable holdings) or in a broader meaning (M2 or M3).
Interest-bearing assets dominate money in the sense of M1 as a store of value (even if only temporarily). M1, on the other hand, is required to conduct trades; in other words, it offers liquidity. This results in a trade-off between the liquidity benefit of storing money for near-term spending and the interest benefit of temporarily holding other assets. The desire for M1 is a result of this trade-off over how a person’s money should be held. The transaction motive and the precautionary motive are the two main reasons why people keep their money in the form of M1 in macroeconomics. The asset demand is based on the demand for those components of the broader money concept M2 that bear a non-trivial interest rate. These can be broken further into more microeconomically based reasons for keeping money.
In general, the nominal demand for money rises with nominal output (price level times real output) and falls with nominal interest rates. The nominal quantity of money required divided by the price level represents the real demand for money. The LM curve is the location of income-interest rate pairs where money demand equals money supply for a given money supply.
The level of money demand volatility has important consequences for how a central bank should conduct monetary policy and what nominal anchor it should use.
In Keynesian theory, conditions where the LM curve is flat and increases in the money supply have little stimulatory effect (a liquidity trap) are essential. When the demand for money is infinitely elastic in relation to the interest rate, this condition obtains.
What causes interest rates to rise as money demand rises?
The demand curve for money is used by economists to depict money demand. The link between the quantity of money demanded and the interest rate is depicted by the money demand curve. Because this is an inverse relationship, it slopes downward. The greater the interest rate on investments like bonds, the more money people want to keep in those investments and less money they want to keep in cash or checking accounts. Bonds sound fairly appealing at an interest rate of 8%, and individuals will likely have a low demand for money because their desire for bonds is so strong. On the other hand, when the interest rate is 4%, the demand for money is likely to be higher.