Question

Which of the following is a reason why increases in the price level result in a decline in aggregate expenditure?

a) Increased consumer spending
b) Increased investment
c) Decreased purchasing power
d) Increased government spending

Answer 1

Increases in the price level result in a decline in aggregate expenditure because of decreased purchasing power, which leads to lower consumption and investment as real incomes decrease and borrowing costs rise.

Step-by-step explanation:

The reason why increases in the price level result in a decline in aggregate expenditure is due to decreased purchasing power. When the general price level rises, consumers and businesses find that the currency they hold buys less than it used to, given the same nominal amount of money. For example, if prices in the economy increase by 10%, but your income stays the same, you can buy less with your income than before. This leads to lower consumption by households because their real income—purchasing power after adjusting for inflation—has decreased.

Moreover, the cost of borrowing also typically increases with higher price levels because lenders charge higher interest rates to compensate for the reduced purchasing power of the money when it's repaid. This diminishes investment spending because firms find it more expensive to finance new projects. Additionally, if consumers anticipate further price rises, they may reduce current spending, preferring to save money to maintain their purchasing power in the future. These elements together contribute to a downward trend in aggregate expenditure as the price level rises.