Suppose money supply decreases, causing the interest rate to rise.What is the effect on GDP?
A) GDP decreases by more than the increase in the interest rate because of the multiplier.
B) GDP decreases by the same amount as the decrease in investment.
C) GDP decreases by more than the decrease in investment because of the multiplier.
D) GDP decreases by less than the decrease in investment because of the multiplier.

Question

Suppose money supply decreases, causing the interest rate to rise.What is the effect on GDP?  
A) GDP decreases by more than the increase in the interest rate because of the multiplier. 
B) GDP decreases by the same amount as the decrease in investment. 
C) GDP decreases by more than the decrease in investment because of the multiplier. 
D) GDP decreases by less than the decrease in investment because of the multiplier.

Quizplus · Accepted Answer

A decrease in money supply leads to an increase in interest rates, which increases the cost of borrowing for firms and households. This, in turn, reduces investment and consumption spending, leading to a decrease in aggregate demand and ultimately a decrease in GDP. The decrease in investment spending is likely to be smaller than the decrease in GDP because of the multiplier effect - a decrease in investment spending will lead to lower income and spending for firms and households, which will in turn reduce aggregate demand by a larger amount than the initial decrease in investment spending. Therefore, GDP decreases by more than the decrease in investment because of the multiplier.

Suppose Money Supply Decreases, Causing the Interest Rate to Rise