Chapter 4R, Problem 2MCQ

To determine

To determine the effect of a fall in investment spending due to an increase in the interest rate on aggregate demand and supply.

Explanation of Solution

An increase in interest rate will decrease the investment component of the aggregate demand. It will shift the aggregate demand to the left, decreasing both the economy’s output and aggregate price level. So, aggregate demand will decrease. Therefore, option (b) is correct.

An increase in interest rate will decrease the investment. Investment is a component of aggregate demand. Therefore, if investment declines, aggregate demand cannot increase. Hence option (a) is incorrect.

An increase in interest rate will bring change in the aggregate demand. So, the change in interest does affect aggregate demand. Thus, option c is incorrect.

Interest rate is not a supply-side variable. Therefore any change in interest rate does not affect the aggregate supply. The aggregate supply neither increases nor decreases due to an increase in the interest rate. Hence, options (d) and ( e) are incorrect.

Economics Concept Introduction

Interest rate is considered the cost of investment. Therefore, these two variables share an inverse relationship. Whenever there is an increase/decrease in the interest rate, it leads to a fall/rise in the investment component of the aggregate demand.