Suppose that consumer spending initially rises by $5 billion for every 1 percent

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 (without the multiplier effect) shift at each price level?

The aggregate demand curve will shift (leftward/rightward) by $ _____ billion.

In what direction and by how much will it eventually shift (with the multiplier effect)?

The aggregate demand curve will shift (rightward/leftward) by $ _____ billion.

Explanation / Answer

1) rightward; 15 billion

2) rightward; 60 billion

Explanation:

When household wealth decreases by 5 percent due to the declining house values the initial shift in aggregate demand will be to the left (fall in real GDP) by $25 billion ( = 5%fall in wealth * $5 consumer spending for every change of 1%). When real interest rate decreases by 2% the initial shift in aggregate demand will be to the right (rise in real GDP) by $40 billion ( = 2% fall in interest rate * $20 investment spending for every change of 1%). Thus the net effect is a positive $15 billion

As multiplier equals 4, the aggregate demand curve will shift to the rightward by $60 billion

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