Chapter 20: Problem 2

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

Expert verified

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.

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