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According to the interest rate effect explanation for why the aggregate demand curve slopes downward, what happens to investment and consumption spending when the price level rises?
AThey rise, since higher prices always lift profits
BThey are unaffected by the price level at all
CThey fall, since costlier credit raises interest rates
DThey fall only for government spending, not private spending
Answer & Solution
Correct answer: C. They fall, since costlier credit raises interest rates
1. A higher price level means the same purchases require more money or credit to complete.
2. That extra demand for money and credit pushes interest rates higher.
3. Higher interest rates discourage business borrowing for investment and household borrowing for homes and cars.
4. So both investment and consumption spending fall as the price level rises, which is another reason AD slopes down.
_Source: OpenStax Principles of Macroeconomics for AP Courses (CC BY 4.0), Ch 10 "The Aggregate Demand/Aggregate Supply Model", section 10.2 | Building a Model of Aggregate Demand and Aggregate Supply_
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