Everything else being the same, what is the effect of an increase in interest rates on...

Everything else being the same, what is the effect of an increase in interest rates on the price level? Discuss the process of adjustment to the new equilibrium.

Expert Solution

( A rise in the price level reduces people's wealth ( wealth effect ) the purchasing power of assets owned falls , so consumption spending will fall as the price level rises . The interest rate effect explains that as outputs rise when price level rises , the same purchases will take more money or credit to be accomplished . This additional demand for money and credit will push interest rates higher .

Thus an increase in the price level (i.e., inflation) will cause an increase in average interest rates in an economy . In contrast, a decrease in the price level (deflation) will cause a decrease in average interest rates in an economy .)

Now interest rate rises first here , this causes investment spending to fall . Investment spending is a part of Aggregate Demand . So real GDP falls . This means that price level rises because AD curve depicts an inverse relation between price level and real GDP .

Rahul Sunny answered 6 months ago

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