What is the effect of tariffs on aggregate demand?

Choosing the option that tariffs can increase domestic prices and potentially boost domestic production is correct because it captures the primary economic mechanisms behind how tariffs function. When a government imposes tariffs on imported goods, it raises the cost of those imports. This price increase makes imported goods less competitive compared to domestic products, leading consumers and businesses to shift their purchases toward domestically produced alternatives.

As domestic products become more attractive due to relatively lower prices (after accounting for tariffs) or due to a nationalist push for local goods, domestic producers may see an increase in demand. This boost can lead to higher domestic production levels as businesses respond to the increased demand by expanding output or making investments.

Moreover, higher prices for imported goods can result in overall inflationary pressure, impacting consumer purchasing behavior and shifting spending patterns within the economy. Thus, the mechanics of tariffs can stimulate domestic production while also influencing aggregate demand positively through increased spending on local goods.

In contrast, other options don’t capture this dynamic effectively. While tariffs may impact domestic production and consumption choices, the notion that they have no impact or only affect imports ignores the interconnected nature of an economy where domestic demand and supply are intricately related to international trade policies.