Question

Explain the change in the nominal interest rate in the short run if a. Real GDP increases. b. The money supply increases. c. The price level rises.

Short answer

Nominal interest rate rises when real GDP increases or price level rises, and falls when money supply increases.

Step-by-step solution

Title - Explain the change in nominal interest rate when Real GDP increases

When real GDP increases, the demand for money also increases because people and businesses need more money to carry out transactions. With a higher demand for money and a stable money supply, the nominal interest rate tends to rise in the short run.

Title - Change in nominal interest rate when Money Supply increases

When the money supply increases, there is more money available in the economy. This increase in supply lowers the nominal interest rate because banks have more money to lend, and thus, they reduce the interest rates to attract borrowers.

Title - Change in nominal interest rate when Price Level rises

When the price level rises, people need more money to buy the same amount of goods and services. Hence, the demand for money increases. With a stable money supply, this increased demand leads to higher nominal interest rates in the short run.

Key concepts

real GDP and interest rates

When real Gross Domestic Product (GDP) increases, it means that the economy is growing. Businesses are producing more goods and services, and people are earning more money.
However, with economic growth, there is usually a higher demand for money. People need more money for day-to-day transactions, investments, and consumption.
This increased demand for money, while the money supply remains unchanged, puts upward pressure on the nominal interest rate. It's like everyone needing more cash, but the amount of cash available hasn't changed.
So, in the short run, if real GDP goes up, the nominal interest rate typically rises. Banks charge higher rates because more people and businesses are competing for the same amount of money available.

money supply impact

The money supply is the total amount of money available in the economy. Central banks, like the Federal Reserve in the USA, control the money supply.
When the central bank increases the money supply, banks have more money to lend. This increased supply of money comes without an immediate increase in the demand for money.
As a result, banks lower their interest rates to attract borrowers. It's like having an excess of something; the price (interest rate) goes down to encourage usage.
In the short run, when the money supply increases, nominal interest rates typically decrease. This makes borrowing cheaper and can stimulate economic activity.

inflation and interest rates

Inflation means that the general price level of goods and services is rising. When prices go up, people need more money to buy the same things they used to buy for less.
This increase in the price level means there's a higher demand for money. But if the money supply stays the same, this increased demand leads to higher nominal interest rates.
Banks need to charge higher interest rates because more people need money to keep up with rising prices.
Therefore, in the short run, if the price level rises, the nominal interest rate tends to go up as well. The cost of borrowing increases to meet the higher demand for money due to inflation.