It has been argued by some that, "An increase in defense spending will cause GDP to fall because the resulting higher interest rates will depress investment." What is wrong with that argument?
A) Higher interest rates may depress investment, but that is a consequence of an increase in aggregate demand and thus GDP; GDP, therefore, will not fall.
B) Every increase in defense spending is accompanied by an increase in tax receipts, so there is no interest rate increase to depress investment.
C) Defense spending is not part of aggregate demand and thus has no effect on GDP.
D) Higher interest rates stimulate investment; the sign of the effect is wrong.
E) None of the above; the statement is true.

Question

Quizplus · Accepted Answer

Higher interest rates may indeed depress investment, but this is typically a result of increased aggregate demand, which includes government spending on defense. When the government increases its defense spending, it contributes to aggregate demand, which can lead to higher GDP. The argument incorrectly assumes that higher interest rates, which might result from increased borrowing to finance defense spending, would directly lead to a fall in GDP. However, the initial effect of increased defense spending is to raise aggregate demand and thus GDP, even if higher interest rates later potentially dampen investment.

It Has Been Argued by Some That, "An Increase in Defense