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According to the interest rate effect theory higher prices will lead to lower GDP demanded because firms will spend less due to loans being more expensive.

It seems at odds with what the SRAS curve tells us about how suppliers (i.e. firms) react to changes in prices in the short term. At higher prices they supply more GDP in the short run.

We get quite strange situation. At higher prices firms will spend less, but at the same time supply more. Assuming that the SRAS didn't increase, how is it even possible?

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  • $\begingroup$ What do you mean by higher prices, do you mean higher general price level? $\endgroup$ – Tan Yong Boon Mar 5 at 1:51
  • $\begingroup$ @TanYongBoon Yes $\endgroup$ – user161005 Mar 5 at 2:13
  • $\begingroup$ Since real i/r = nominal i/r - inflation rate, rising price levels would translate to lower real interest rates. Lower real interest rates encourage firms to borrow money to invest. Why do you say that higher price levels mean more expensive loans? $\endgroup$ – Tan Yong Boon Mar 5 at 2:23
  • $\begingroup$ @TanYongBoon Higher price level leads to people consuming more and saving less. Less savings are available to be lended. Interest rate increases for this reason, leading to more expensive loans. Source:youtu.be/oLhohwfwf_U?t=471 $\endgroup$ – user161005 Mar 5 at 3:06

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