Factors that Shift Aggregate Demand

At each price level, the AD curve shifts to the right due to changes in C, I, G, and X.

• An increase in real wealth: greater wealth increases the demand for all goods.
• Increased optimism about the future: both current consumption and investment increase.
• High capacity utilization: companies have to increase investment spending to expand production.
• Expanding fiscal policy: higher government spending and lower taxes will increase G and C.
• An increase in money supply: higher income and expenditure.
• A lower interest rate - when borrowing is cheaper, investment increases; consumption is cheaper with a lower interest rate.
• A decrease in exchange rate: increases export demand.
• Growth in the global economy: increases export demand.

And vice versa.

Factors that Shift Aggregate Supply

We need to differentiate between the long-run and short-run effects.

Increases in short-run aggregate supply (SRAS) that don't affect long-run aggregate supply are caused by:

• A decrease in resource prices/production costs (e.g., nominal wages, input prices). Unless the lower prices of resources reflect a long-term increase in the supply of resources, they will not alter LRAS.
• A reduction in the expected rate of inflation. If high inflation is expected, suppliers would like to reduce supplies now to sell them at higher prices later but consumers would like to spend more money now.
• Lower business taxes and higher government subsidies.
• Favorable exchange rates for importers of raw materials.

And vice versa.

Long-run supply refers to the economy's long-run production possibilities (maximum rate of sustainable output). Increase in long-run aggregate supply (LRAS) is caused by:

• An increase in the supply of resources. This will expand the economy's sustainable rate of output. Note that an economy's resource base includes physical capital, natural resources and human capital.
• An improvement in technology and productivity. This will increase the average output per unit of resources.

And vice versa.

Practice Question 1

Suppose you notice that when the price level falls, the real value of your money increases. This induces you to increase your level of consumption. This is an example of the ______.

A. wealth effect
B. interest rate effect
C. real effect
D. income effect
E. international trade effect

Correct Answer: A

Practice Question 2

Which of the following will cause an INCREASE in aggregate demand?

A. A decrease in the price level
B. An increase in the money supply
C. An increase in labor productivity
D. A decrease in government spending
E. An improvement in technology

Correct Answer: B

An increase in the supply of money will increase aggregate demand. A decrease in the price level is a movement along the curve, not a shift in aggregate demand. A decrease in government spending reduces aggregate demand, and the other factors change aggregate supply, not aggregate demand.

Practice Question 3

A change in any of the following factors except ______ could cause the aggregate demand curve to shift.

A. fiscal policy
B. expectations
C. price level
D. monetary policy

Correct Answer: C

Practice Question 4

If the price level rises, then real wealth ______, consumption ______, and aggregate demand ______.

A. decreases; decreases; decreases
B. increases; decreases; decreases
C. decreases; increases; increases

Correct Answer: A

Practice Question 5

Which of the following will increase aggregate demand?

I. Higher prices in a stock market
II. Higher prices in a real estate market
III. Higher real wealth

A. III only
B. I, II, III
C. None of them. They will increase the quantity of aggregate demand but not the aggregate demand itself.

Correct Answer: B

Increases in stock and housing prices increase the real wealth of households and thus increase aggregate demand.

Practice Question 6

If people expect that the nominal interest rate will be higher in the near future, the aggregate demand ______

A. will increase.
B. will decrease or stay at the same level.
C. could increase, decrease, or stay at the same level.

Correct Answer: C

It depends on the expected inflation rate. If it is higher than the expected increase of the nominal interest rate, the real interest rate is expected to go down and people will spend more. On the other hand, the aggregate demand will decrease. If the two rates are equal, the aggregate demand will stay unchanged.

Practice Question 7

An appreciation of the U.S. dollar would ______ (increase, decrease, not affect) aggregate demand and an increase in the real interest rate would ______ (increase, decrease, not affect) aggregate demand.

A. increase; decrease
B. decrease; increase
C. decrease; decrease

Correct Answer: C

An appreciation of the dollar would make U.S. goods and services more expensive to foreigners and would reduce exports. An increase in the real interest rate would depress domestic investment spending and spending on consumer durables such as automobiles and refrigerators. Spending on U.S. exports, investment spending, and consumer spending are components of aggregate demand.

Practice Question 8

Which of the following will shift the aggregate demand curve for the U.S. to the right?

A. A decrease in the exchange rate for the euro
B. A drop in the price level
C. An economic boom in Europe

Correct Answer: C

The shift indicates an increase in aggregate demand. An economic boom in Europe would lead to higher incomes there and increased demand for U.S. exports. A decreased exchange rate for the euro is an increase in the exchange rate for the dollar, or an increase in interest rate would decrease aggregate demand. A drop in the price level would not shift the aggregate demand curve. It would instead cause a movement downward along the existing aggregate demand curve.

Practice Question 9

A drop in the price level would ______

A. shift the aggregate demand curve to the right.
B. shift the aggregate demand curve to the left.
C. not shift the aggregate demand curve at all.

Correct Answer: C

It increases the quantity of goods demanded, and will cause a movement along the demand curve (not a shift of the curve).

Practice Question 10

Which of the following will cause an increase in aggregate demand in the United States?

A. An increase in the real interest rate or a decrease in the stock market share prices
B. An increase in the pessimism of business and consumers about future economic conditions
C. An increase in the expected rate of inflation

Correct Answer: C

People will buy now before prices go higher. Thus, the expectation of an increase in the inflation rate will stimulate current aggregate demand.

Practice Question 11

Which of the following will reduce U.S. aggregate demand?
I. The economic recession in Japan and Western Europe
II. A decrease in recession fears
III. An increase in real interest rates in the U.S.

A. II and III
B. I and III
C. I, II and III

Correct Answer: B

An increase in the real interest rate makes both consumer durable goods and investment projects more expensive, thus reducing aggregate demand. The recession in Japan and Western Europe will reduce demand for U.S. goods (U.S. exports) by people in these countries.

Practice Question 12

Which of the following will cause aggregate demand to increase?

A. An increase in the money supply
B. An increase in taxes
C. A decrease in the price level

Correct Answer: A

An increase in the money supply will increase aggregate demand. An increase in taxes lowers AD; any change in the price level moves along the same curve.

Practice Question 13

Which of the following will shift the LAS curve to the right?
I. An increase in the supply of resources
II. Improved technology
III. A substantial increase in the minimum wage for young workers
IV. Lower interest rates

A. I and II
B. All of these factors
C. II and IV

Correct Answer: A

The resource base and level of technology determine the LAS.

Practice Question 14

A decrease in resource prices will ______ short-run aggregate supply and ______ long-run aggregate supply.

A. increase; increase
B. increase; not affect
C. not affect; increase

Correct Answer: B

The size of the economy's resource base changes the long-run aggregate supply and resource prices change the short-run aggregate supply. Unless the lower prices of resources reflect a long-term increase in the supply of resources, they will not alter long-run aggregate supply.

Practice Question 15

If people expect a higher rate of inflation, the SAS will ______ and LAS will ______.

A. decrease; not be affected
B. increase; not be affected
C. not be affected; not be affected (Changes in inflation expectations will impact demand, not supply.)

Correct Answer: A

If people expect a higher inflation rate, sellers' incentive to sell at a given price in the current period will be reduced; goods that they do not sell today will be available for sale in the future at what they anticipate will be even higher prices. SAS will decrease. However, this expectation does not have a long-term effect since LAS is determined by technology, resource base, and institutional factors only.

Practice Question 16

Which of these changes will affect short-term supply but not long-term supply?

I. Changes in resource prices
II. Changes in the expected rate of inflation
III. Supply shocks
IV. An increase in the resource base

A. I, II, III
B. I, III
C. All of these changes

Correct Answer: A

An increase in the resource base will affect long-term supply; the rest of the changes will affect short-term supply only.

Practice Question 17

Changes in the expected inflation rate will affect ______.

I. aggregate demand
II. short-run aggregate supply
III. long-run aggregate supply

A. I and II
B. I and III
C. I, II, and III

Correct Answer: A

Expectations do not change LRAS, since it is determined by technology, resource base, and institutional factors.