In the short run, an increase in the policy rate will cause:

• A. an increase in aggregate demand due to higher consumer spending
• B. a decrease in the price level due to increased government spending
• C. a decrease in the supply of money as banks lend more
• D. a decrease in investment spending due to higher borrowing costs

Answer: (D)

Verified step by step guidance

1. Understand the role of the policy rate (often the central bank's interest rate) in the economy. It influences borrowing costs for consumers and firms.
2. Recognize that an increase in the policy rate raises the cost of borrowing money, making loans more expensive for businesses and consumers.
3. Analyze how higher borrowing costs affect investment spending: firms are less likely to take loans for new investments, leading to a decrease in investment spending.
4. Recall that aggregate demand is composed of consumption, investment, government spending, and net exports. A decrease in investment spending reduces aggregate demand.
5. Conclude that the correct short-run effect of an increase in the policy rate is a decrease in investment spending due to higher borrowing costs, which can slow economic activity.