Question

When the supply of credit is fixed, an increase in the price level stimulates the demand for credit, which, in turn, reduces consumption and investment spending. This effect is called the a. real balances effect. b. interest-rate effect. c. net exports effect. d. substitution effect.

Short answer

The correct response is the interest-rate effect (Choice B). This effect occurs when an increase in the price level stimulates the demand for credit, leading to a higher interest rate. As borrowing becomes more expensive, consumption and investment spending decrease.

Step-by-step solution

Choice A. Real Balances Effect

The real balances effect is the change in aggregate spending resulting from changes in the value of money balances when the general price level changes. When the price level increases, the purchasing power of money balances decreases, and vice versa. However, this effect does not focus specifically on the demand for credit, so it is not the correct answer choice in this case.

Choice B. Interest-Rate Effect

The interest-rate effect is the change in aggregate spending that results from changes in the interest rate caused by changes in the price level. When the price level increases, the demand for credit increases because people need more money to spend on goods and services. This increase in credit demand leads to a higher interest rate, which makes borrowing more expensive. As a result, businesses and consumers are less likely to spend money on new investments or consumption, reducing spending in both areas. This effect fits the description given in the exercise, so the correct answer is Choice B: interest-rate effect.

Choice C. Net Exports Effect

The net exports effect is the change in total spending caused by changes in the price level that affect the volume of international trade. Specifically, it refers to how changes in the price level can affect the balance of exports and imports. This effect is not related to the description given in the exercise, which focuses on the demand for credit and its effect on consumption and investment spending.

Choice D. Substitution Effect

The substitution effect is the change in the consumption of a good or service when relative prices change, causing consumers to choose one product over another due to changes in its relative price or utility. This effect typically arises in the context of microeconomic decisions and does not directly explain the macroeconomic outcome described in the exercise. Based on the analysis of each answer choice, the correct response is: b. interest-rate effect.

Key concepts

Aggregate Spending

Aggregate spending refers to the total amount of spending in an economy, encompassing all areas such as consumption, investment, government spending, and net exports. It's a crucial measure as it reflects overall economic activity and can help gauge the health of an economy.

When discussing aggregate spending, it is important to note the different components that contribute to it:

• Consumption: Spending by households on goods and services. This is typically the largest component and is influenced by factors such as income levels and interest rates.
• Investment: Spending by businesses on capital goods. This includes expenditures on buildings, machinery, and technology, and is sensitive to changes in interest rates.
• Government Spending: Includes all government expenditures on goods and services. This can be influenced by fiscal policies.
• Net Exports: The value of a country’s exports minus its imports. This can fluctuate based on global economic conditions and exchange rates.

If interest rates rise due to the interest-rate effect, both consumption and investment can decrease, leading to a reduction in aggregate spending. This relationship highlights the interconnectedness between price levels, credit demand, and aggregate spending in an economy.

Demand for Credit

The demand for credit involves the desire of individuals and businesses to borrow money. When price levels increase, the demand for credit often rises because people and companies need more money to maintain their purchasing power for goods and services.

Several factors can influence the demand for credit:

• Price Levels: An increase in price levels can lead individuals and companies to borrow more to afford the same standard of living or operational capacity.
• Interest Rates: Interest rates directly impact the cost of borrowing. As rates increase, the demand for credit usually decreases because borrowing becomes more expensive.
• Economic Conditions: In a robust economy, the demand for credit generally rises as businesses expand and consumers feel more confident about taking on debt.

Understanding the demand for credit is crucial because it influences the interest rates set by financial institutions. Higher demand for credit can drive up interest rates, which in turn can affect spending decisions by consumers and businesses.

Price Level

The price level represents the average of current prices across the entire spectrum of goods and services produced in the economy. It is an essential indicator of economic inflation and purchasing power.

When the price level changes, it can have significant effects on various economic factors:

• Purchasing Power: As price levels rise, the value of money falls, reducing purchasing power. People need more money to purchase the same amount of goods and services.
• Interest-Rate Effect: An increase in the price level can lead to an increased demand for credit, as individuals require more funds. This can cause interest rates to rise, reducing the willingness and ability of people to consume and invest.
• Inflation: Sustained increases in the price level often lead to inflation, which can impact economic decisions and long-term financial planning.

In sum, changes in the price level can prompt shifts in economic behavior, affecting everything from individual saving and consumption habits to broader aggregate spending patterns.