Question

Assuming that the money demand function depends on income, the interest rate and the price level as presented in class, then if planned investment decreases as the interest rate increases, the size of the government spending multiplier for expansionary fiscal policy will be than it was when we ignored the money market.

A) exactly the same
B) smaller
C) larger

Answer 1

Step-by-step explanation:

The right response is B) smaller.

Step-by-step explanation:

An increase in interest rates results in a fall in planned investment because businesses and individuals borrow less money to invest and hold more money instead when the money demand function depends on income, the interest rate, and the price level.

For a given rise in government spending, a decrease in projected investment will result in a minor increase in the overall demand for goods and services and a lesser increase in output. As a result, the government spending multiplier will be lower than it would be if the money market were ignored.

As a result, choice B) is the appropriate response.

Option A) is erroneous because it assumes that interest rates do not impact investment or the demand for money. This is because the money market is ignored. This presumption is false and goes against the way money demand works.

Option C) is erroneous since considering the money market will reduce the multiplier, even if government expenditure can still have a positive multiplier effect on output.

B) smaller