How can Real GDP increase while Money Supply remains fixed?

Question

I'm studying the Money Market Graph with it's Money Demand and Money Supply curves. In the classical model they teach the Money Demand curve as sloping down to the right while the Money Supply curve is a vertical line as it's fixed by the Fed.Reserve(and can only be altered by its 3 Monetary Policies). And the point where they meet as the Equilibrium Interest rate.

Now comes the part where I get confused. When discussing the shifters of the Money Demand Curve, let’s use Real GDP for example, they say that an increase in Real GDP means an Increase in Incomes on Average which Means an increase in Consumer Spending and this means an increase shift of the Money Demand Curve. But since Money Supply stays the same, the result is a greater new equilibrium interest rate.

My question is how can Money Supply stay the same if the average persons salary/spending in the economy increased as a byproduct of Real GDP increase? Are they instead trying to say, albeit in a confusing way, that their purchasing power goes up(deflation of prices) rather than the nominal amount of money they have which in essence is the reason for the new equilibrium interest rate?

Because according to the model,a vertical Money Supply line would mean that there is the same amount of money in both the before and after Money Demand Increase scenarios in which case the average person must have the same amount of money even after the Increase in Real GDP so there is no nominal increased Incomes or spending but rather increased purchasing power.

Basically, the way I understand it is that I, an average person in the economy, have 3000 dollars before the Money Demand Increase. After the Money Demand shift due to increase in Real GDP, I want more money, and so does every other average Joe, but there isn't any as the Money Supply is fixed. So I don't get any nominal salary increase (stay at 3000) or nominal spending increase BUT I do get cheaper prices for goods and services (Deflation) and I do get higher interest rates on my savings/interest-bearing assets. Am I on the right track with my thinking?

I hope my question was clear. Thanks

Answer 1

My question is how can Money Supply stay the same if the average persons salary/spending in the economy increased as a byproduct of Real GDP increase?

Real GDP is GDP adjusted for changes in price level. If nominal GDP in 2000 and 2001 is 100 and in 2001 price level drops (lets say deflator drops from 1 to 0.5) real GDP in 2000 will be 1000 (since that is our base year) and in 2001 real GDP will be 200 despite the fact that nominal GDP is 100 in both years. Money supply/amount of money people get does not determine their real income.

Hence real GDP or even real wage can increase without you having any more money. If you get paid 1000 euro each month and price level drops, your income increases, this leads to higher consumption and that requires higher money demand (e.g. see discussion in Blanchard et al Macroeconomics Ch 5).

Are they instead trying to say, albeit in a confusing way, that their purchasing power goes up(deflation of prices) rather than the nominal amount of money they have which in essence is the reason for the new equilibrium interest rate?

Yes this is exactly what they are saying. Remember in standard model any time you see $P$ and $Y$ separately, like in standard Keynesian LM curve $(P/M = L(Y,i))$, $Y$ is always real income. Generally the standard models work with real variables unless stated otherwise. So if textbook or a paper says 'income increased' generally it is meant to say real income increased (unless stated otherwise or you are dealing with some strand of literature that does not follow this convention).

Answer 2

You can calculate real GDP as number of goods and services you can afford.

If the economy can supply you with longer life, better health, more food, more sex and more shelter for less money, then the real GDP grows despite nominal GDP being constant.

So, you can earn just \$1000 monthly, but if it costs you \$10000 to build a house, you are extremely rich, because you can afford to build a house every year or two.