According to liquidity-preference theory, how does a decrease in the price level affect the interest rate and output demanded, respectively?
A) The interest rate increases, and output demanded increases.
B) The interest rate increases, and output demanded decreases.
C) The interest rate decreases, and output demanded increases.
D) The interest rate decreases, and output demanded decreases.

Question

Quizplus · Accepted Answer

According to liquidity-preference theory, a decrease in the price level increases the real money supply. This leads to a lower interest rate because people have more money than they want to hold, so they lend it or invest it, which lowers the interest rate. A lower interest rate, in turn, stimulates investment and consumption, leading to an increase in output demanded.

According to Liquidity-Preference Theory, How Does a Decrease in the Price