In macroeconomics, what does the interest-rate effect suggest about how a higher price level influences money demand, interest rates, and spending?

Introduction / Context:
This question examines your understanding of the interest rate effect, one of the channels through which changes in the overall price level influence aggregate demand in macroeconomics. The interest rate effect focuses on how price level changes alter the demand for money, the equilibrium interest rate, and therefore interest sensitive components of spending such as consumption and investment.

Given Data / Assumptions:
- The economy has a monetary system where households and firms hold money balances.
- The central bank keeps the nominal money supply initially fixed in the short run.
- We are analysing the impact of an increase in the general price level on money demand, interest rates, and spending.

Concept / Approach:
When the price level rises, households and firms need more money to carry out the same volume of transactions. With a fixed nominal money supply, an increase in money demand puts upward pressure on the interest rate. As interest rates rise, the cost of borrowing increases and some planned investment and big ticket consumption falls. Thus aggregate demand decreases through lower consumption and investment. The correct option must mention higher price level, higher money demand, higher interest rates, and lower consumption and investment spending.

Step-by-Step Solution:
Step 1: Identify the option in which a higher price level raises the demand for money. Step 2: Among those, check which one describes interest rates rising, not falling, when money demand increases with a fixed money supply. Step 3: From those statements, choose the one that connects higher interest rates to lower consumption and investment spending. Step 4: Option B fits all these conditions and therefore correctly summarises the interest rate effect.

Verification / Alternative check:
An alternative check is to recall the money market diagram. A higher price level shifts the money demand curve to the right, leading to a higher equilibrium interest rate where the fixed money supply line intersects the new demand curve. Then recall the downward sloping investment demand curve: higher interest rates reduce investment, which in turn reduces aggregate demand. This mental picture reinforces option B.

Why Other Options Are Wrong:
Option A claims that higher price level reduces interest rates, which contradicts basic money market analysis. Option C talks about a decrease in the money supply rather than a change in the price level, so it describes a different mechanism. Option D incorrectly states that a higher price level decreases money demand and reduces interest rates, which is opposite to standard theory, and it incorrectly claims that spending increases when rates fall in that way in this context.

Common Pitfalls:
Students often confuse shifts in money supply with shifts in money demand. Another common mistake is to forget that in the short run the nominal money supply is assumed fixed, so only money demand moves when the price level changes. Some also mix up the income effect and the interest rate effect, treating all channels of aggregate demand as identical. Keeping a clear chain of reasoning from price level to money demand to interest rates to spending helps avoid these errors.

Final Answer:
The correct choice is An increase in the price level will increase the demand for money, increase interest rates, and decrease consumption and investment spending..