Question

The demand curve in an individual market slopes down because of the income effect, the substitution effect, and diminishing marginal utility. Looking at the macro Aggregate Demand Curve, describe the three reasons why an increase in the overall price level results in lower aggregate expenditures: real-balance effect, interest-rate effect, and foreign-purchases effect. (Explain each of these three effects.)​

Answer 1

Real balance effect: Increase in price level reduces the purchasing power of income and wealth. This results in lower consumption and hence aggregate expenditure.

Interest rate effect: The increase in price level leads to higher interest rate. Investment level is inversely related to interest rate. Hence, investment falls leading to lower aggregate expenditure when there is rise in price level.

Foreign purchase effect: When domestic price level rises, imports become relatively cheaper. Hence, consumers shift from domestic goods to foreign goods i.e exports fall and imports rise. This leads to lower aggregate expenditure.