Question

Assume that prices and wages adjust rapidly so that the markets for labor, goods, and assets are always in equilibrium. What is the effect of the following event on output, the real interest rate, and the current price level? Event: An increase in the interest rate paid on checking accounts. Output 'Y: Real interest rate 'r: Current price level 'P:

Answer 1

When interest rates are raised the amount of credit available in markets decrease and subsequently the corporates have lower degree of cash flows and thus capital expenditure reduces and job losses begin which cause lower disposable incomes and thus the consumption declines and so does the real GDP or Output falls. As a result the demand falls and prices or inflation both fall.

Now since inflation falls the real interest rates also rise in tandem.