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 3.

a. 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?

Answer 1

According to the question, every 1 percent rise in household wealth leads to increase in consumer spending by $5 billion.

Also, every 1 percentage point fall in the real interest rate leads to increase in investment spending by $20 billion.

and the economy's multiplier is 3.

( a ) Fall in real interest rate by 3 percentage point will increase investment spending by 3*20 = $60 billion, whereas fall in household wealth by 5 percent will decrease consumer spending by 5*5=$25 billion.

We also know that aggregate demand = Consumer spending + government spending + Investment spending.

Net effect would be an increase in spending ( 60 - 25 ) = $35 billion.

Given that multiplier = 3

An increase in total spending will lead to an increase aggregate demand = 3*35= $105 billion.

Therefore aggregate demand curve would shift to the right due to an increase in aggregate demand by $105 billion.