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 2 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?

Short answer

The AD curve will initially move to the right by $15 billion.

The AD curve will eventually move by $60 billion to the right.

Step-by-step solution

Initial change in the AD curve

The household spending (consumption expenditure) changes by $5 billion for every 1% change in the household wealth.Thus, a fall in the consumption wealth by 5% will reduce the consumption by $25 billion (= $5 billion × 5).

On the other hand, a fall in interest rate by 1% increases the investment by $20 billion.Thus, a 2% fall in the interest rate will increase the investment by $40 billion (= $20 billion × 2).

Thus, the net effect of changes in consumption expenditure and investment in the aggregate demand is as follows:

𝛥AD =𝛥Investment –𝛥Consumption

𝛥AD = $ (40 – 25) billion

𝛥AD = $15 billion

Thus, the aggregate demand curve will initially shift rightward by $15 billion.

Induced change in the AD curve

The multiplier value, as given in the question, is 4. Therefore, an initial increase of $15 billion in aggregate expenditure will eventually increase the aggregate demand by four times.

𝛥AD = k ×𝛥Aggregate Expenditure

𝛥AD = 4 × $15 billion

𝛥AD = $60 billion

Therefore, the aggregate demand will eventually increase by $60 billion, and the AD curve will further shift rightward by $60 billion.