Final answer:
C. Rise in our domestic price level will increase our imports and reduce our exports, thereby reducing the net exports component of aggregate demand
The foreign purchases effect indicates that an increase in domestic prices leads to higher imports and lower exports, reducing the net exports component of aggregate demand. Answer C is correct.
Step-by-step explanation:
The foreign purchases effect on aggregate demand suggests that a rise in our domestic price level will increase imports and reduce exports, thereby reducing the net exports component of aggregate demand. Therefore, the correct answer is C. A rise in our domestic price level will increase our imports and reduce our exports, thereby reducing the net exports component of aggregate demand.
When domestic prices increase while prices in other countries remain fixed, goods and services from the domestic market become more expensive relative to those from other countries. As a result, domestic consumers become more inclined to purchase relatively cheaper imports, and foreigners find the higher-priced domestic exports less attractive, leading to a reduction in the quantity of exports sold. This dynamic is essential in understanding the foreign price effect, which explains the negative relationship between the price level and net exports, contributing to the downward slope of the aggregate demand curve.