Question

The interest-rate effect suggests that:

A) a decrease in the supply of money will increase interest rates and reduce interest-sensitive consumption
and investment spending.
B) an increase in the price level will increase the demand for money, reduce interest rates, and decrease
consumption and investment spending.
C) an increase in the price level will increase the demand for money, increase interest rates, and decrease
consumption and investment spending.
D) an increase in the price level will decrease the demand for money, reduce interest rates, and increase
consumption and investment spending.

Answer 1

The correct answer is C) an increase in the price level will increase the demand for money, increase interest rates, and decrease consumption and investment spending, as higher price levels lead to higher demand for money, which raises interest rates and discourages borrowing for consumption and investment.

Step-by-step explanation:

The interest rate effect suggests that an increase in the price level will lead to an increased demand for money because more capital is required to make the same purchases as before. This increase in demand for money and credit applies upward pressure on interest rates, which results in higher borrowing costs. Consequently, businesses may choose to borrow less for investment and individuals may also reduce their borrowing for purchasing homes and cars, therefore, consumption and investment spending decrease. Given this explanation, the correct answer to the student's question is: C) an increase in the price level will increase the demand for money, increase interest rates, and decrease consumption and investment spending.