Question

The _________ effect occurs when an increase in the aggregate price level reduces the purchasing power of households' and firm's money holdings, leading to an increase in interest rates and falling consumption and investment.

Answer 1

Interest Rate effect

Step-by-step explanation:

Interest rate effect is basically the changes in borrowing and spending behaviors resulting from interest rate adjustments. It is the change in the interest rate due to changes in the overall price level. Changes in the level of expenditure in real production, occurs because changes in price level changes interest rate which in turn affects the cost of borrowing. A higher price level increases interest rate which reduces borrowing used for investment and consumption expenditures. While a lower price level results in decrease in interest rate, thus increasing borrowing used for investment and consumption expenditures.