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Chapter 23: Problem 2

Explain which components of aggregate expenditure are affected by a change in the price level.

Short Answer

Expert verified
All components of aggregate expenditure - consumption, investment, government spending, and net exports - can be affected by changes in the price level. Rising prices often lead to decreased consumption and investment due to reduced real income and purchasing power. It can also decrease the real value of government purchases and make domestic goods less competitive, negatively impacting net exports.

Step by step solution

01

Understand Aggregate Expenditure

Aggregate expenditure is the total spending in an economy. It is calculated as the sum of 4 components: consumption (C), investment (I), government spending (G), and net exports (NX) which is exports minus imports.
02

Explain the Effect of Price Level on Consumption and Investment

As the price level rises, the real value of people's income falls which may lead to lower consumption. Higher prices can also discourage investment because they can reduce the purchasing power of future returns from investment. So, an overall increase in the price level can potentially decrease consumption (C) and investment (I).
03

Describe the Impact on Government Spending and Net Exports

Government spending (G) is determined by political decisions and budget constraints, not directly by the price level. However, when prices rise and inflation increases, the real value of government purchases decreases. Net exports (NX) might also fall when prices go up if domestic goods become more expensive than foreign goods, leading to an increase in imports and a decrease in exports.

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Most popular questions from this chapter

What is likely to happen if firms accumulate large amounts of unplanned inventory at the beginning of a recession?

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