Question

Suppose that consumer spending initially rises by $5 billion for every 1 percent rise in household wealth and that investment spending initially rises by $20 billion for every 1 percentage point fall in the real interest rate. Also assume that the economy’s multiplier is 4. If household wealth falls by 5 percent because of declining house values, and the real interest rate falls by 3 percentage points, in what direction and by how much will the aggregate demand curve initially shift at each price level?

The aggregate demand curve will shift  (select : rightward or leftward ) by $( )  billion.

In what direction and by how much will it eventually shift?

The aggregate demand curve will shift    (select : rightward or leftward ) by $ ( ) billion.

Answer 1

Every 1 percent rise in household wealth lead to rise in consumption spending by $5 billion.

So, alternatively, every 1 percent fall in household wealth would lead to fall in consumption spending by $5 billion.

Thus, a 5% fall in household wealth leads to fall in consumption spending by (5 * $5 billion) $25 billion.

Every 1 percent fall in the real interest rate leads to increase in investment spending by $20 billion.

So, fall in real interest rate by 3 percent would lead to increase in investment spending by ($20 billion * 3) $60 billion.

Both consumption spending and investment spending are part of aggregate demand.

So, a decrease in consumption spending by $25 billion and an increase in investment spending by $60 billion leads to net increase in aggregate demand by $35 billion.

So,

Initially, the aggregate demand curve will shift rightward by $35 billion.

Eventual increase in AD = Initial increase in AD * Multiplier = $35 billion * 4 = $140 billion

So,

Eventually, the aggregate demand curve will shift rightward by $140 billion.