Question : The interest rate effect states that an increase in the price level leads to:
Option 1: An increase in the interest rate
Option 2: A decrease in the interest rate
Option 3: No change in the interest rate
Option 4: An increase in savings
Correct Answer:
An increase in the interest rate
Solution : The correct answer is (a) An increase in the interest rate.
The interest rate effect states that an increase in the price level leads to an increase in the interest rate. This effect occurs due to changes in the demand for money and the supply of loanable funds in the economy.
When the price level rises, individuals and businesses require more money to make their purchases. As a result, the demand for money increases. To meet this increased demand, individuals and businesses may seek additional loans from financial institutionsTo secure loans in a competitive lending market, borrowers are willing to pay a higher interest rate. As a result, the interest rates in the economy increase.
