Check Your Understanding

1. Question

   Determine the effect on aggregate demand of each of the following events. Explain whether it represents a movement along the aggregate demand curve (up or down) or a shift of the curve (leftward or rightward).

   1. a rise in the interest rate caused by a change in monetary policy

      This is a shift of the aggregate demand curve. A decrease in the quantity of money raises the interest rate, since people now want to borrow more and lend less. A higher interest rate reduces investment and consumer spending at any given aggregate price level, so the aggregate demand curve shifts to the left.

   2. a fall in the real value of money in the economy due to a higher aggregate price level

      This is a movement up along the aggregate demand curve. As the aggregate price level rises, the real value of money holdings falls. This is the interest rate effect of a change in the aggregate price level: as the value of money falls, people want to hold more money. They do so by borrowing more and lending less. This leads to a rise in the interest rate and a reduction in consumer and investment spending. Thus, it is a movement along the aggregate demand curve.

   3. news of a worse-than-expected job market next year

      This is a shift of the aggregate demand curve. Expectations of a poor job market, and so lower average disposable incomes, will reduce people’s consumer spending today at any given aggregate price level. Thus, the aggregate demand curve shifts to the left.

   4. a fall in tax rates

      This is a shift of the aggregate demand curve. A fall in tax rates raises people’s disposable income. At any given aggregate price level, consumer spending is now higher. Thus, the aggregate demand curve shifts to the right.

   5. a rise in the real value of assets in the economy due to a lower aggregate price level

      This is a movement down along the aggregate demand curve. As the aggregate price level falls, the real value of assets rises. This is the wealth effect of a change in the aggregate price level: as the value of assets rises, people will increase their consumption plans. This leads to higher consumer spending. Thus, it is a movement along the aggregate demand curve.

   6. a rise in the real value of assets in the economy due to a surge in real estate values

      This is a shift of the aggregate demand curve. A rise in the real value of assets in the economy due to a surge in real estate values raises consumer spending at any given aggregate price level. Thus, the aggregate demand curve shifts to the right.