Question

The interest rate effect suggests that

A. an increase in the price level increases the money supply, which causes businesses and consumers to increase desired spending.

  

B. a decrease in the price level decreases the interest rate, which causes businesses and consumers to reduce desired spending.

  

C. an increase in the price level increases the interest rate, which causes businesses and consumers to reduce desired spending.

  

D. an increase in the price level decreases the interest rate, which causes businesses and consumers to reduce desired spending.

Answer 1

The interest rate effect refers to the change is borrowing and spending patterns when interest rate changes. A rise in interest rates will decrease borrowing and desired spending while a fall in interest rates will increase desired spending. Based on this definition lets consider each option-

A. an increase in the price level increases the money supply, which causes businesses and consumers to increase desired spending. - An increase in price level decreases the money supply (Ms/P - Prises, Ms/P falls).So the statement is incorrect. As money supply decreases, competition for lonable funds rise - raising interest rates and decreasing desired spending. Incorrect option.

B.  a decrease in the price level decreases the interest rate, which causes businesses and consumers to reduce desired spending. - A decrease in price level increases the real money balance (Ms/P - P falls, Ms/P rises). This decreases interest rates and increases desired spending. Incorrect option.

C. an increase in the price level increases the interest rate, which causes businesses and consumers to reduce desired spending. - An increase in price level will reduce the real money supply. This will raise competition for loanble funds and raise interest rates. Higher interest rate will crowd out investments and spending and so desired spending falls. correct option

D. an increase in the price level decreases the interest rate, which causes businesses and consumers to reduce desired spending. - An increase in price level, decreases real money balance and will cause interest rates to be higher. This discourage borrowings which discourages the desired spending. Incorrect option

So option C is correct.