Tuesday, July 26, 2011
Interest Rate Effect
It is possible to see how the interest rate effect is exogenously affecting the demand for real GDP by looking at the the money market shown in the upper quadrant of the diagram.
When the price level rises, consumers demand more money to make purchases. Their demand shifts from point 1 to point 2 and the interest rate rises to allocate a fixed amount of money supply.
So the price level rises and people buy less. I believe that the higher interest rate induced savings which I denote as an S in the lower diagram. A change in the price level upward, also increases the nominal interest rate that induces savings. Of course, if the price level were to fall, interest rates would fall.