I will use the IS-LM (investment-saving & liquidity preference money supply) model to explain this relationship between the interest rate and GDP. However, this IS-LM model is conceived in a perfect world environment which means that the aggregate demand and supply are a zero-sum game (equal balance) and this perfect world is not true in the real world.
The IS-LM diagram is showing that a cut in interest rate will increase the real GDP output (Y) before the interest rate must be raised to prevent an overheating GDP (Y) which will cause the GDP (Y) to decline again. Basically, the black dot on the IS-LM diagram will move in a cycle accordingly to the interest rate movements.
Since we have a visual understanding of the relationship between the interest rate and the real GDP output, we can move on to understand the real GDP output growth. There is only real GDP output growth when there is additional production of goods and services.
Thus, the real GDP output growth formula (production function) is:
Y = A * f(K, L)
A=Productivity
K=Capital
L=Labour quantity
As we can see from the production function, K is affected by the interest rate movement because a cut in interest rate will lower the cost of capital which will encourage business investments in machinery and equipment to improve productivity (A). The lower cost of capital will also encourage the hiring of labour to operate and maintain the additional equipment and new machinery. In other words, K will affect A and L which in turn will push up Y. This manipulation of K also applies to the service sector.
I hope our viewers will have a better understanding of the monetary policy (Interest rate) now after reading my post.
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