Question

When government expenditures increase, the interest rate

a. decreases, making the change in aggregate demand smaller.
b. increases, making the change in aggregate demand larger.
c. decreases, making the change in aggregate demand larger.
d. increases, making the change in aggregate demand smaller

Answer 1

The correct answer is option d.

Step-by-step explanation:

When there is an increase in the government expenditures, the income in the economy will increase. As a result, the demand will increase. The increase in demand will increase the price level.

The suppliers will produce more. To increase output more capital investment will be required. This will further cause an increase in the demand of loan-able funds. So, the interest rate will increase as well.

With the increase in interest rates, the cost of borrowing will increase. This will lead to lesser capital investment and as a result the aggregate demand will be smaller, because of lower production and thus lower income.