Question

There is a difference between a change in the interest rate that is brought about by a change in the price level and a change in the interest rate that is brought about by a change in some factor other than the price level. The first will change the quantity demanded of Real GDP, and the second will change the \(A D\) curve. Do you agree or disagree with this statement? Explain your answer.

Short answer

The given statement is correct. The change in price level can lead to a change in the interest rate, thereby affecting the quantity demanded of Real GDP. In addition, a change in the interest rate due to factors other than price levels can shift the AD curve.

Step-by-step solution

Understanding the impact of price level changes on the interest rate and Real GDP

If there is inflation (increase in price level), central banks often react by raising the interest rate to slow down the economy and curb inflation. Conversely, in times of deflation (decrease in price level), central banks lower the interest rate to stimulate economic activity. This change in interest rate, in turn, affects the quantity demanded of Real GDP. With a higher interest rate, borrowing becomes more expensive, reducing investment and spending, thus reducing the demand for Real GDP. Therefore, the first part of the statement is true.

Understanding the impact of non-price level factors on the interest rate and AD Curve

The interest rate can change due to factors other than price level, such as monetary policy, investor sentiments, and changes in the global economy. An increase in the interest rate (due to anything other than price level changes), makes borrowing more expensive and disincentivizes investment, thereby reducing the aggregate demand. In turn, this shifts the AD curve to the left. Similarly, a decrease in interest rate, increases the aggregate demand, shifting the AD curve to the right. This confirms the second part of the statement.