An increase in real GDP can shift A. money demand to the right and decrease the equilibrium interest rate. B. money demand to the left and increase the equilibrium interest rate. C. money demand to the right and increase the equilibrium interest rate. D. money demand to the left and decrease the equilibrium interest rate.
The correct answer and explanation is:
Correct Answer: C. money demand to the right and increase the equilibrium interest rate.
Explanation (300 words):
An increase in real GDP generally means that the economy is producing more goods and services, and households and businesses have more income and wealth. As a result, there is a greater demand for money because people and firms engage in more transactions—buying, selling, investing, and hiring. This leads to a rightward shift in the money demand curve.
In the money market, the supply of money is typically fixed in the short run and controlled by the central bank (such as the Federal Reserve or Central Bank of Kenya). When money demand increases (shifts to the right) while the money supply remains constant, this creates upward pressure on the interest rate.
This happens because people now want to hold more money for transactions, but since the quantity of money hasn’t changed, they are willing to bid up the interest rate to obtain the cash they need. In equilibrium, the interest rate must rise until the quantity of money demanded equals the quantity supplied.
Graphically, imagine the vertical money supply curve and a money demand curve shifting to the right. The new intersection point occurs at a higher interest rate, confirming that the cost of borrowing money increases due to higher demand.
Therefore, option C is correct because:
- An increase in real GDP → more economic activity → higher demand for money.
- Higher money demand → rightward shift in the demand curve.
- Money supply remains fixed → interest rate must rise to reach new equilibrium.
This relationship is a key part of monetary economics and helps explain how economic growth can affect the financial sector, especially through changes in interest rates, which in turn influence investment and consumption decisions in the economy.