MacroEcon Aplia ch.20: Aggregate Demand and Aggregate Supply

As the price level falls, the cost of borrowing money will FALL, causing the quantity of output demanded to RISE. This phenomenon is known as the INTEREST RATE effect.

Explanation-- If the price level falls, people will need less money to carry out day-to-day transactions. As people demand less money, the cost of borrowing money—the interest rate—will fall (assuming that the quantity of money in the economy is fixed). As a result, business investment speeds up, leading to an increased demand for domestic output. This is known as the interest rate effect of a change in the price level. Note that a lower interest rate increases not only investment spending, but also consumer spending, as people will want to save less. So, at a lower interest rate, business investment increases and household saving decreases, leading to an increased demand for domestic output.

Complete the table by indicating the change in each determinant necessary to increase aggregate demand. Change Needed to Increase AD Wealth: Increase Taxes: Decrease Expected rate of return on investment: Increase Incomes in other countries: Increase

Explanation-- The level of consumer spending depends, in part, on household wealth. As household wealth rises, consumer spending rises at each price level. An increase in consumer spending leads to an increase in aggregate demand. A decrease in taxes increases households' disposable income. Households will spend more, causing aggregate demand to increase at each price level. The rate of return that businesses expect on capital projects is a key determinant of investment. Suppose a technological breakthrough causes an increase in the expected return on investment. Investment spending will rise, and aggregate demand will increase at each price level. When the incomes of foreigners increase, foreigners will purchase more domestic products, causing exports to rise. Because net exports are one component of aggregate demand, this increase in net exports (exports minus imports) leads to an increase in aggregate demand at each price level.

Additionally, as the price level falls, the impact on the domestic interest rate will cause the real value of the dollar to FALL in foreign exchange markets. The number of domestic products purchased by foreigners (exports) will therefore RISE, and the number of foreign products purchased by domestic consumers and firms (imports) will FALL. Net exports will therefore RISE, causing the quantity of domestic output demanded to RISE. This phenomenon is known as the EXCHANGE RATE effect.

Explanation-- When an economy's price level falls, consumers require less money to purchase a given basket of goods and services, so that money demand falls, causing the domestic interest rate to fall. Investors respond to lower domestic interest rates by seeking higher returns abroad. As domestic investors attempt to convert dollars into foreign currency to buy foreign assets, the supply of dollars increases in the market for foreign-currency exchange, and the real value of the dollar falls. When each dollar buys fewer units of foreign currencies, foreign goods become more expensive than domestic goods. Because of dollar depreciation, foreigners find domestic goods to be relatively inexpensive. Exports of domestic goods to foreigners therefore rise, while domestic imports of foreign goods fall. Net exports (exports minus imports) therefore rise, leading to a rise in the quantity of domestic output demanded. The tendency for a fall in the price level to decrease the real exchange rate and increase net exports is known as the exchange rate effect.