How does an increase in interest rates affect real GDP?

An increase in interest rates increases the incentive to save, as the reward for saving is now higher. So, saving in the economy is likely to increase, which will decrease consumption (assuming that people's incomes stay the same). An increase in interest rates increases the cost of borrowing, and therefore the cost of investing. This discourages businesses from investing and, as a result, investment in the economy decreases. The government debt interest payments will rise due to the higher cost of borrowing - but we cannot predict the effect this will have on government spending. So, we will ignore it for the purposes of this question. The effect on net exports will be determined by how our trade partners' interest rates are changing. Assuming they stay the same, there will be an appreciation in the exchange rate. This makes foreign imports cheaper for UK residents and UK exports more expensive for foreign countries, which will decrease net exports. Aggregate demand (AD) = consumption (C) + investment (I) + government spending (G) + net exports (X-M)Since C, I and (X-M) will all decrease, AD will also decrease. This will shift the AD curve inwards, and there will be a resulting contraction down the AS curve. Both price level and real GDP will fall. So, an increase in interest rates will - ceteris paribus - cause real GDP to decrease.