Question

Refer to the above diagrams. A decline in aggregate expenditures from AE2

to AE1 resulting from the real balances, interest rate effect, and foreign purchases effects would be depicted as:
A) a movement from A to C along aggregate demand curve AD1.
B) a movement from C to A along aggregate demand curve AD1.
C) a shift of aggregate demand from AD1
to AD2.
D) a shift of aggregate demand from AD2
to AD1

Answer 1

The decline in aggregate expenditures from AE2 to AE1 due to real balances, interest rate, and foreign purchases effects would be depicted as a movement from C to A along aggregate demand curve AD1 (Option B).

Step-by-step explanation:

This movement along the aggregate demand curve signifies a decrease in aggregate expenditures. When real balances (related to purchasing power), interest rates (impacting borrowing costs), and foreign purchases affect spending, it results in a reduction in aggregate demand. Moving from a higher level of expenditures (AE2) to a lower one (AE1) on the same AD1 curve indicates a contraction in overall demand without changing the curve's position.

The real balances effect pertains to changes in the purchasing power of consumers, influencing their spending decisions. Simultaneously, alterations in interest rates and foreign purchases can impact the total spending in an economy. These effects cause a downward shift in aggregate expenditures along the existing AD1 curve, represented by the movement from C to A.

The correct answer is option B, a movement from C to A along aggregate demand curve AD1.

Answer 2

The decline in aggregate expenditures from AE2 to AE1 would be depicted as a movement from A to C along aggregate demand curve AD1.

Step-by-step explanation:

This decline in aggregate expenditures would be depicted as a movement from point A to point C along the aggregate demand curve AD1. Let's break down these effects and understand how they contribute to the decline:

1. Real Balances Effect: This effect refers to changes in consumer spending due to changes in the purchasing power of their money. When the price level decreases (deflation), the value of money increases, making consumers feel wealthier and more willing to spend. As a result, aggregate expenditures increase. Conversely, when the price level increases (inflation), the value of money decreases, reducing consumers' purchasing power and leading to a decrease in aggregate expenditures. In this case, the decline in aggregate expenditures is driven by a decrease in real balances, possibly due to an increase in the price level.

2. Interest Rate Effect: Changes in interest rates influence the cost of borrowing for consumers and businesses, impacting their spending decisions. When interest rates decrease, borrowing becomes cheaper, encouraging consumers and businesses to spend more. This increase in spending leads to higher aggregate expenditures. On the other hand, when interest rates increase, borrowing becomes more expensive, discouraging spending and resulting in a decrease in aggregate expenditures. In this scenario, the decline in aggregate expenditures is driven by an increase in interest rates, which reduces borrowing and spending.

3. Foreign Purchases Effect: This effect relates to changes in net exports (exports minus imports) due to changes in the exchange rate. When the domestic currency depreciates (loses value) compared to other currencies, exports become relatively cheaper, while imports become relatively more expensive. This makes domestic goods and services more competitive in the international market, leading to an increase in net exports and thus higher aggregate expenditures. Conversely, when the domestic currency appreciates (gains value), exports become relatively more expensive, imports become relatively cheaper, and net exports decrease. This decrease in net exports contributes to a decline in aggregate expenditures. In this case, the decline in aggregate expenditures is driven by an appreciation of the domestic currency, leading to a decrease in net exports.