An increase in total production (real GDP) causes the demand for money to ______and the interest rate to _________

Analyze the question: It asks what happens to money demand and the interest rate when real GDP (total output) rises.

Concept:

• People hold money mainly for transactions and precautionary motives. These needs rise with income and output.
• When real GDP rises, more goods and services are bought and sold, so more money is needed for transactions.
• With the money supply held fixed, a higher demand for money pushes the price of holding money, the interest rate, upward.

Step-by-step solution:

1. Real GDP rises, so incomes and the volume of transactions rise.
2. Demand for money increases (the money demand curve shifts right).
3. The money supply is unchanged, so there is excess demand for money at the old interest rate.
4. People sell bonds or borrow more to get cash, bond prices fall, and the interest rate rises.

Result: Demand for money increases and the interest rate increases.

Why the others are wrong:

• A: Money demand rises, but the interest rate does not fall unless the money supply increases.
• B and D: Money demand does not decrease when output rises.

Exam tip: Remember "Y up, Md up, i up" (income up, money demand up, interest rate up). A rise in the interest rate with higher output comes from the money demand curve shifting right while the money supply stays fixed.