Other things being equal, the higher the price level, the lower the level of domestic output purchased. This occurs because of:
A) interest rate effect, foreign trade effect and supply effect
B) interest rate effect, foreign trade effect and wealth effect
C) employment effect, foreign trade effect and wealth effect
D) interest rate effect, expected inflation effect and wealth effect

Question

Quizplus · Accepted Answer

The correct answer is B) interest rate effect, foreign trade effect, and wealth effect. These three effects explain why, when the price level rises, the quantity of domestic output purchased tends to fall. The interest rate effect suggests that higher prices lead to higher interest rates, which dampen investment and consumption. The foreign trade effect indicates that higher domestic prices make domestic goods more expensive relative to foreign goods, reducing exports and increasing imports. The wealth effect posits that as prices rise, the real value of money decreases, reducing consumers' purchasing power and thus their consumption.

Other Things Being Equal, the Higher the Price Level, the Lower