Explain how a decrease in interest rates affects real GDP and inflation. When may a decrease in the interest rate not affect real GDP?

When interest rates decrease, this decreases the cost of borrowing and reduces the reward for saving. As a result, there is a higher incentive for firms and individuals to borrow/spend and a lower incentive for them to save. This increases investment (I) and consumption (C). Since Aggregate Demand (AD) = Consumption (C) + Investment (I) + Government Spending (G) + Exports (X) - Imports (M), an increase in C and I shifts the AD curve up from AD1 to AD2. At this new equilibrium point, real GDP has increased from Y1 to Y2 and the price level has increased from PL1 to PL2. Therefore, a decrease in interest rates causes a rise in real GDP and inflation.
When the interest rate is already low (e.g. 0.5%), a decrease in the interest rate (e.g. to 0.25%) may not have the same affect on real GDP. This is because a small decrease in the interest rate may not decrease the cost of borrowing and reduce the reward for saving enough to stimulate an increase in C and I. As a result, the AD curve will not shift upwards and real GDP will not increase.

Answered by India B. Economics tutor

14731 Views

See similar Economics A Level tutors

Related Economics A Level answers

All answers ▸

Explain why the price of average tickets has risen by £10 in the last month. Use a supply and demand diagram. (5 marks)


What is the difference between an elastic good and an in-elastic good?


Using Angola as an example, evaluate the view that MNCs play a positive role in the development of LEDCs. (25 marks)


Explain the term 'equilibrium' and demonstrate how a new equilibrium position is established when there is a decrease in demand for a good or service.


We're here to help

contact us iconContact usWhatsapp logoMessage us on Whatsapptelephone icon+44 (0) 203 773 6020
Facebook logoInstagram logoLinkedIn logo

© MyTutorWeb Ltd 2013–2025

Terms & Conditions|Privacy Policy
Cookie Preferences