Which of the following best describes the relationship between interest rate, aggregate income, and price level in the context of macroeconomics?

• A. Aggregate income and interest rates are unrelated to changes in the price level.
• B. A decrease in interest rates always causes the price level to fall and aggregate income to rise.
• C. An increase in the price level leads to higher interest rates and lower aggregate income.
• D. Higher aggregate income always results in lower interest rates and a lower price level.

Answer: (C)

Verified step by step guidance

1. Step 1: Understand the key macroeconomic variables involved: interest rate (i), aggregate income (Y), and price level (P). These variables interact through mechanisms such as the money market and goods market.
2. Step 2: Recall the liquidity preference theory, which states that the demand for money depends positively on aggregate income (Y) and negatively on the interest rate (i). The money supply is fixed by the central bank, so equilibrium in the money market determines the interest rate.
3. Step 3: Recognize that an increase in the price level (P) raises the nominal money demand because people need more money for transactions. Given a fixed money supply, this increased demand for money pushes the interest rate (i) up to restore equilibrium.
4. Step 4: Higher interest rates make borrowing more expensive, which tends to reduce investment and consumption, leading to a decrease in aggregate income (Y). This is the transmission mechanism from price level to income via interest rates.
5. Step 5: Summarize the relationship: an increase in the price level (P) leads to higher interest rates (i), which in turn lowers aggregate income (Y). This explains why the correct statement is that an increase in the price level leads to higher interest rates and lower aggregate income.