Question 49

The inverse relationship between real GDP and the price level is explained by the increase in consumer spending as real wealth rises.

As prices fall, the real wealth of individuals who hold a fixed quantity of money increases, which leads to an increase in consumer spending. This mechanism illustrates how a decrease in the price level can stimulate economic activity through enhanced purchasing power.

A) As prices fall the demand of money increases, raising the real interest rate and encouraging investment and consumption

This option is incorrect because it suggests that falling prices lead to an increase in money demand, which would actually raise real interest rates. Higher interest rates typically discourage investment and consumption rather than encourage it, contradicting the premise of the AD-AS framework.

B) As prices fall the real wealth of people holding a fixed quantity of money increases leading to an increase in consumer spending

This option accurately describes the inverse relationship. When prices decrease, the purchasing power of money increases for individuals, which boosts their real wealth and subsequently leads to an increase in consumer spending, thereby stimulating real GDP.

C) As prices fall the government reduces taxes, leading to an increase in the quantity of goods and services purchased

This choice is not relevant to the AD-AS framework regarding the inverse relationship between real GDP and price levels. While tax reductions can stimulate demand, this is not a direct consequence of falling prices and does not explain the mechanism at hand.

D) As prices fall the domestic consumers import more goods and services

While it is true that lower prices may lead consumers to purchase more imports, this does not explain the inverse relationship between real GDP and the price level in the context of the AD-AS framework. Increased imports can actually detract from domestic GDP rather than stimulate it.

Conclusion

Option B is the only choice that accurately captures the relationship between decreasing price levels and increasing real GDP through enhanced consumer spending. The other options either misrepresent economic principles or fail to directly address the question, reinforcing why B is the correct and most relevant explanation within the AD-AS framework.