Question

Which of the following best describes the multiplier process?

		A.  A decrease in exports leads to a reduction in taxes, which causes government spending to fall.
		B.  An increase in interest rates leads firms to cut their investment spending. That causes expectations of future profits to worsen, which leads to even more cuts in investment spending.
		C.  A decline in net exports leads firms to reduce their investment spending, which raises interest rates and causes further reductions in investment spending.
		D.  A decrease in investment spending leads to a decrease in disposable income, which causes consumers to reduce their spending.

Answer 1

B. An increase in interest rates leads firms to cut their investment spending. This causes expectations of future profits to worsen, which leads to even more cuts in investment spending.

(Multiplier process explains the changes in the variable due to a change in the associated variable. Here, investment and interest rate are negatively related. So, as interest rate increases investment decreases, which worsens expectation of future profit and this in turn will further reduce investment.)