Which of the following is a reason why increases in the price level result in a decline in aggregate expenditure? a. Price level increases raise real wealth, which causes consumption spending and aggregate expenditure to decline. b. Price level increases cause firms and consumers to hold more money, which raises the interest rate, ceteris paribus. Higher interest rates lower consumption and planned investment expenditures, which lowers aggregate expenditure. c. Price level increases in Australia relative to other countries raise net exports, which lowers aggregate expenditure. d. As the price level rises, government spending falls, which lowers aggregate expenditure.
Question
Which of the following is a reason why increases in the price level result in a decline in aggregate expenditure?
a. Price level increases raise real wealth, which causes consumption spending and aggregate expenditure to decline.
b. Price level increases cause firms and consumers to hold more money, which raises the interest rate, ceteris paribus. Higher interest rates lower consumption and planned investment expenditures, which lowers aggregate expenditure.
c. Price level increases in Australia relative to other countries raise net exports, which lowers aggregate expenditure.
d. As the price level rises, government spending falls, which lowers aggregate expenditure.
Solution
The correct answer is:
b. Price level increases cause firms and consumers to hold more money, which raises the interest rate, ceteris paribus. Higher interest rates lower consumption and planned investment expenditures, which lowers aggregate expenditure.
When the price level increases, people need more money to carry out their usual transactions. This increases the demand for money, which can lead to higher interest rates. Higher interest rates can discourage consumption and investment because borrowing becomes more expensive. This can lead to a decline in aggregate expenditure.
Options a, c, and d are incorrect. Option a is incorrect because an increase in real wealth would typically increase, not decrease, consumption spending. Option c is incorrect because an increase in net exports would increase, not decrease, aggregate expenditure. Option d is incorrect because government spending is not directly affected by changes in the price level.
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