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Describe how the following changes affect the aggregate demand (AD) curve. Your ...

May 4, 2024

Describe how the following changes affect the aggregate demand (AD) curve. Your answer must state clearly which component of the aggregate demand is affected and how AD curve eventually shifts. (i) Firms are pessimistic about the future sales. (2 marks) (ii) The government has announced a reduction in personal taxes. (2 marks) (iii) The currency of a country depreciates against major trading partners. (2 marks) (iv) The central bank cuts interest rates to boost market sentiment. (2 marks)

i Solution

Impact on Investment Component: When firms are pessimistic about future sales, they are likely to reduce investment spending

Shift of AD Curve: A decrease in investment spending will cause the aggregate demand curve to shift to the left

i Answer

The aggregate demand curve will shift to the left due to a decrease in investment spending caused by firms' pessimism about future sales.

Key Concept

Investment Component of AD

Explanation

Firms' pessimism about future sales leads to reduced investment, which decreases aggregate demand.

ii Solution

Impact on Consumption Component: A reduction in personal taxes increases disposable income, which can lead to an increase in consumer spending

Shift of AD Curve: An increase in consumer spending will cause the aggregate demand curve to shift to the right

ii Answer

The aggregate demand curve will shift to the right due to an increase in consumer spending following a reduction in personal taxes.

Key Concept

Consumption Component of AD

Explanation

Lower personal taxes raise disposable income, leading to higher consumer spending and increased aggregate demand.

iii Solution

Impact on Net Exports Component: Currency depreciation makes a country's goods cheaper for foreign buyers, increasing exports and decreasing imports

Shift of AD Curve: An increase in net exports will cause the aggregate demand curve to shift to the right

iii Answer

The aggregate demand curve will shift to the right due to an increase in net exports caused by currency depreciation.

Key Concept

Net Exports Component of AD

Explanation

A depreciating currency increases net exports by making domestic goods more competitive abroad, thus increasing aggregate demand.

iv Solution

Impact on Investment Component: Lower interest rates reduce the cost of borrowing, encouraging firms and consumers to increase investment and consumption

Shift of AD Curve: An increase in investment and consumption will cause the aggregate demand curve to shift to the right

iv Answer

The aggregate demand curve will shift to the right due to increased investment and consumption following a cut in interest rates.

Key Concept

Interest Rates and AD

Explanation

Lower interest rates reduce borrowing costs, stimulating investment and consumption, which in turn increases aggregate demand.