Question

Starting from a short-run equilibrium, show and explain how an increase of the discount rate affects GDP, using the money-interest, the expenditure schedule and the AD-AS graphs. Assuming that at the initial point the GDP is below the potential GDP, explain how self-correcting mechanisms work. What could the government do in order to improve the situation?

Answer 1

Discounts rate is a kind of charges or interest rate on commercial banks and other financial institutions for receiving loans from the central bank of the country. When discount rate increases, it affect the supply of the money in the economy because at the higher rate of discount rate commercial banks can not lend money but at the low discount rate supply of money generally increases. Ultimately, it would affect the GDP also. At the high rate of supply of money economic activities would also improve by the side of investors because they would receive money at a low-interest rate which would promote more production and income will also increase.