Question

2) . 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 two percentage points, in what direction and by how much will the aggregate demand curve initially shift at each price level? In what direction and by how much will it eventually shift?

Answers: rightward by $15 billion; rightward by $60 billion.

Feedback: Suppose that consumer spending initially rises by $5 billion for every 1 percent rise in household wealth. If household wealth falls by 5 percent because of declining house values the initial shift in aggregate demand will be to the left (decline in real GDP) by $25 billion ( = 5 (percent decline in wealth) x $5 (consumer spending for every 1% change)). Note the positive relationship between wealth and consumer spending.

Also, suppose that investment spending initially rises by $20 billion for every 1 percentage point fall in the real interest rate. If the real interest rate falls by two percentage points the initial shift in aggregate demand will be to the right (increase in real GDP) by $40 billion ( = 2 (percentage point decline in interest rate) x $20 (investment spending for every 1 percentage point change)). Note the inverse relationship between the interest rate and investment.

The combined initial effect is a shift to the right of the aggregate demand curve by $15 billion. There is a decrease of $25 billion from consumer expenditure and an increase of $40 billion from investment expenditure, thus, the net effect is a positive $15 billion.

Given that the multiplier is 4, the aggregate demand curve will shift to the right by $60 billion after the multiplier process works its way through the economy ( = 4 (multiplier) x $15 billion (initial net impact on aggregate demand).

Answer 1

Initial shift:
As household wealth initially falls, so, consumer spending will fall. Thus, Change in AD = (Change in wealth)*(Change in consumer spending) = (5%)*(-5) = -25 billion.
Fall in real interest rate will increase investment. So, increase in AD = (Change in real interest rate)*(Change in investment spending) = (2%)*20 = 40 billion
Total change in AD = 40 + (-25) = $15 billion
Thus, AD will initially shift rightward by $15 billion at each price level.

Eventual shift:
Eventual change in AD = Multiplier*(Initial change in AD) = 4*15 = $60 billion
Thus, AD will eventually shift rightward by $60 billion.