Final answer:
The interest rate represents both a cost of borrowing and a return on saving. A decrease in interest rates boosts consumption by lowering borrowing costs and decreasing saving returns; an increase in the price level can cause higher interest rates, reducing borrowing and spending. Conversely, an increase in loanable funds leads to lower interest rates.
Step-by-step explanation:
The term we're looking at here is interest rate, which serves as both a cost of borrowing and a return on saving. When interest rates decrease, this typically encourages consumption because the cost of borrowing is reduced, making loans more attractive for consumers and businesses. Likewise, the return on savings is lower, which can lead some individuals to prefer spending over saving. Conversely, an increase in the price level can push interest rates higher due to more money or credit being required for purchases, which in turn, reduces consumption and investment by making borrowing less attractive.
An important economic phenomenon related to interest rates is the interest rate effect. This states that as the price level increases, the demand for money and credit also increases, leading to higher interest rates. Subsequently, higher interest rates reduce the amount of borrowing for investments and consumption, such as homes and cars, thus reducing consumption and investment spending.
Furthermore, an increase in the availability of loanable funds means there are more potential lenders in the market, which drives down the interest rate, incentivizing more borrowing but discouraging saving. Contrarily, a contractionary policy that reduces the amount of loanable funds in the economy would lead to higher interest rates because of the increased scarcity of loanable funds.