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Nelson Education > Higher Education > Exploring Macroeconomics, Second Canadian Editon > Student Resources > Section Review Questions/Answers > Chapter 8

Section Review Questions/Answers

Chapter 8: Aggregate Demand

8.1 The Determinants of Aggregate Demand

1. What are the major components of aggregate demand?

The major components of aggregate demand are consumption, investment, government purchases, and net exports.

2. If consumption is a direct function of disposable income, how does an increase in personal taxes or a decrease in transfer payments affect consumption?

Either an increase in taxes or a decrease in transfer payments decreases the disposable income of households, which reduces their demands for consumption goods.

3. Would you spend more or less on additional consumption if your marginal propensity to consume increased?

Because the definition of the marginal propensity to consume is the fraction of an increase in disposable income one would spend on additional consumption purchases, you would spend more, the higher your marginal propensity to consume.

4. What would an increase in exports do to aggregate demand, other things being equal? An increase in imports? An increase in both imports and exports, where the change in exports was greater in magnitude?

An increase in exports would increase aggregate demand, other things being equal, because net exports are part of aggregate demand. An increase in imports would decrease aggregate demand, other things being equal, by reducing net exports (demand shifts from domestic producers to foreign producers). An increase in both imports and exports will increase aggregate demand if the increase in exports exceeds the increase in imports, other things being equal, because the combination will increase net exports.

8.2 The Investment and Saving Market

1. Why does the investment demand curve slope downward?

As the real interest rate falls, additional investment projects with lower expected rates of return become profitable for firms, and the quantity of investment demanded rises.

2. What factors can shift the investment demand curve?

The investment demand curve would increase (shift to the right) if firms expect higher rates of return on their investments; if product and process innovation reduces the costs of production; if profitable new products are developed; if inventories are depleted below the levels desired by firms; if forecasts for future expected sales are strong; or if business taxes are lowered. The investment demand curve would decrease (shift to the left) in the opposite situations.

3. Why does the saving supply curve slope upward?

At a higher real interest rate, the reward for saving and supplying funds to financial markets is greater, leading to an increased quantity of saving supplied.

4. What factors can shift the saving supply curve?

The saving supply curve would increase (shift to the right) if disposable (after tax) income rose or if people expected lower future earnings. The saving supply curve would decrease (shift to the left) if disposable (after tax) income fell or if people expected higher future earnings.

5. How is the real interest rate determined?

The real interest rate is determined by the intersection of the investment demand curve and the saving supply curve, where desired investment equals desired national saving.

6. How are shortages and surpluses eliminated in the investment and saving market?

If the real interest rate was above the equilibrium real interest rate, the quantity of savings supplied would be greater than the quantity of investment demanded—there would be a surplus of savings. As savers (lenders) compete against each other to attract investment demanders (borrowers), the real interest rate will fall toward the equilibrium level. If the real interest rate was below the equilibrium real interest rate, the quantity of savings supplied would be less than the quantity of investment demanded—there would be a shortage of savings. As demanders (borrowers) compete against each other to attract savers (lenders), the real interest rate will rise toward the equilibrium level.

8.3 The Aggregate Demand Curve

1. Why is the aggregate demand curve downward sloping?

Aggregate demand shows what happens to the total quantity of all real goods and services demanded in the economy as a whole (that is the quantity of real GDP demanded) at different price levels. Aggregate demand is downward sloping because of the real wealth effect, the interest rate effect, and the open economy effect as the price level changes.

2. How does an increased price level reduce the quantities of investment goods and consumer durables demanded?

An increased price level increases the demand for money, which, in turn, increases interest rates. Higher interest rates increase the opportunity cost of financing both investment goods and consumer durables, reducing the quantities of investment goods and consumer durables demanded.

3. What is the real wealth effect, and how does it imply a downward-sloping aggregate demand curve?

A reduced price level increases the real value of people’s currency holdings, and as their real wealth increases, so does the quantity of real goods and services demanded, particularly consumption goods. Therefore, the aggregate demand curve, which represents the relationship between the price level and the quantity of real goods and services demanded, slopes downward as a result.

4. What is the interest rate effect, and how does it imply a downward-sloping aggregate demand curve?

A reduced price level reduces the demand for money, which lowers interest rates, which increases the quantity of investment goods and consumer durable goods people are willing to purchase. Therefore, the aggregate demand curve, which represents the relationship between the price level and the quantity of real goods and services demanded, slopes downward as a result.

5. What is the open economy effect, and how does it imply a downward-sloping aggregate demand curve?

The open economy effect occurs because a higher domestic price level raises the prices of domestically produced goods relative to the prices of imported goods. That reduces the quantity of domestically produced goods demanded (by both citizens and foreigners), as now relatively cheaper foreign-made goods are substituted for them. The result is again a downward-sloping aggregate demand curve, as a higher price level results in a lower quantity of domestic real GDP demanded.

8.4 Shifts in the Aggregate Demand Curve

1. How is the distinction between a change in demand and a change in quantity demanded the same for aggregate demand as for the demand for a particular good?

Just as a change in the price of a particular good changes its quantity demanded, but not its demand, a change in the price level changes the quantity of real GDP demanded, but not aggregate demand. Just as a change in any of the demand curve shifters (other factors than the price of the good itself) changes the demand for a particular good, a change in any of the C 1 I 1 G 1(X 2 M) components of aggregate demand not caused by a change in the price level changes aggregate demand.

2. What happens to aggregate demand if the demand for consumption goods increases, ceteris paribus?

Because consumption purchases are part of aggregate demand, an increase in the demand for consumption goods increases aggregate demand, ceteris paribus.

3. What happens to aggregate demand if the demand for investment goods falls, ceteris paribus?

Because planned investment purchases are part of aggregate demand, a falling demand for investment goods makes aggregate demand fall, ceteris paribus.

4. Why would an appreciation of the Canadian dollar decrease aggregate demand?

An appreciation of the Canadian dollar causes exports to fall and imports to rise, thus Canadian net exports fall, and the aggregate demand curve shifts to the left.

 

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