The interest rate effect that helps explain the slope of the aggregate demand curve arises because
A) interest rates and total planned real expenditures are unrelated.
B) an increase in the price level lead to decreases in interest rates, which induces more borrowing and hence raises planned real expenditures.
C) an increase in the price level boosts interest rates, which discourages borrowing and hence reduces planned real expenditures.
D) a decrease in the price level boosts interest rates, which discourages borrowing and hence frees up income for more planned real expenditures.

Question

Quizplus · Accepted Answer

According to the interest rate effect, an increase in the price level boosts interest rates, which discourages borrowing and hence reduces planned real expenditures. This is because as prices rise, demand for money increases, causing interest rates to rise. Higher interest rates discourage borrowing, making it more expensive for firms to finance investment projects and for consumers to purchase big-ticket items such as homes and cars. This decrease in borrowing and spending reduces the quantity of goods and services demanded, resulting in a leftward shift in the aggregate demand curve. Therefore, option C is the correct answer.

The Interest Rate Effect That Helps Explain the Slope of the Aggregate