Chapter 24: Problem 4

Briefly explain how each of the following events would affect the aggregate demand curve. a. An increase in the price level b. An increase in government purchases c. Higher state personal income taxes d. Higher interest rates e. Faster income growth in other countries f. A higher exchange rate between the dollar and foreign currencies

Short Answer

Expert verified

a. AD shifts left. b. AD shifts right. c. AD shifts left. d. AD shifts left. e. AD shifts right. f. AD shifts left.

Step by step solution

Effect of an increase in the price level

An increase in the price level reduces the purchasing power of consumers' money holdings. This is known as the wealth effect. As a result of this decreased purchasing power, consumers will reduce their consumption, and this will lead to a decrease in aggregate demand. Hence, this will shift the AD curve to the left.

Effect of an increase in government purchases

An increase in government purchases directly increases aggregate demand, regardless of the price level. It doesn't matter whether the government is buying military aircraft or paying teacher salaries, the increase in government expenditure will shift the AD curve to the right.

Effect of higher state personal income taxes

Higher state personal income taxes reduces personal disposable income. As people have less income to spend, consumption decreases, which reduces aggregate demand. This will cause a leftward shift of the AD curve.

Effect of higher interest rates

When interest rates increase, people are more likely to save money than spend it as the return on savings is higher. This decreases consumer spending and investment, leading to a decrease in aggregate demand. Therefore, it causes a leftward shift of the AD curve.

Effect of faster income growth in other countries

Faster income growth in other countries can increase the demand for a country's exports, hence increasing net exports. This will subsequently increase the aggregate demand within a country. This will cause a rightward shift of the AD curve.

Effect of a higher exchange rate between the dollar and foreign currencies

If the exchange rate between the dollar and foreign currencies increases, it makes goods and services in the U.S. more expensive compared to other countries. This will decrease the demand for the country's exports and increase its demand for imports. This results in a decrease in net exports and therefore decreases aggregate demand. Hence, the AD curve shifts to the left.