Question

The ratchet effect is the tendency of:

A) the price level to increase but not to decrease.
B) nominal GDP to increase more rapidly than real GDP.
C) real interest rates to fall more rapidly than nominal interest rates.
D) consumption to rise year after year regardless of what happens to disposable income

Answer 1

The ratchet effect is the tendency of price levels to increase but not decrease; the correct answer to the student's question is option A.

Step-by-step explanation:

The ratchet effect refers to the economic concept where price levels have a tendency to increase but not to decrease. Given the options provided, the correct answer is (A) the price level to increase but not to decrease. This concept is based on the observation that prices, once they have increased due to factors like inflation or increased production costs, rarely return to their lower levels even if the driving factors are no longer present.

The interest rate effect, on the other hand, explains how rising prices lead to increased demand for money and credit, hence pushing interest rates higher, which then dampens borrowing and spending for investment and consumption.

This leads to an additional demand for money and credit, pushing interest rates higher and reducing borrowing by businesses and households. As a result, consumption and investment spending decrease.