Aggregate Demand/Supply Sample 1—Real Balances

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One reason why aggregate demand slopes downward and to the right is the Real Balances Effect. When the price level declines, your savings becomes worth more and your buying power is boosted. For the macro economy, the real balances effect can be illustrated as shown. To interpret, suppose that Harriet has $5,000 in cash, and $10,000 in non monetary assets (car, computer, and Android). What is the value of her real balances when the price level is 120? Simply add her assets together, $15,000, and divide by the price level and multiply by 100. The value of her assets when the price level is 120 is $12,500. The value of her real balances when the price level is 100 is $15,000. As the price level falls, Harriet’s buying power increases causing her quantity demanded to increase from Q1 to Q2. When the price level increases, her buying power decreases and the quantity demanded falls. Notice that this is a movement along the curve since the only variable that is changing is the price level. AD1 (0) Assume that Harriet has $15,000 in cash and assets. Compute Harriet’s real balances for each price level in the table below. Price Level Real Balance 80 90 100 110 AD2(0) Suppose the price level changes from 123 to 125. What is the inflation rate? _________ Sample 2 – Interest Rate Effect What is not spent is saved. So when the price level falls, the consumer buys a fixed market basket and save the rest. The supply of savings increases and interest rates fall. The lower interest rates induce more business investment and household consumption of durable goods. The quantity demanded of real GDP increases.

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they will pay back $8.Suppose that when the price level is 120 the interest rate is 8% . they will pay in interest $800. HNI will only pay $600.000. So Alpha citizens buy less domestic goods and the quantity demanded decreases. If the price level drops to 100 and consumers save more.000 in interest. In the example. it’s cheaper for Alpha consumers to buy from Beta. This interest rate effect also works in reverse. WhilWind Workbooks Pantent Pending 2 . AD3 (0) How much interest would HNI have to repay if they wanted to borrow $10 million and the interest rate was 4%? _____________ Sample 3 – Foreign Purchases Effect When the price level is higher in Alpha than the price level in Beta. Alpha and Beta consumers find it cheaper to buy from Beta so the quantity demanded falls from Q3 to Q2. If HNI borrows $10 million to finance capital restructuring. This means that for every $100 dollars a consumer or business borrows. the price level for Alpha increases from A to B. It’s like buying at Walmart* a pair of shoes for $10 instead of buying the shoes at Shoe Carnival for $20.

they spend more. or Nx shifts the curve. Sample 4 – Aggregate Demand Shifts When the price level changes. the economy moves along the aggregate demand curve for three reasons. Anything that changes spending shifts the AD curve. WhilWind Workbooks Pantent Pending 3 . A change in personal taxes and expectations of future prices will shift the curve. G. consumers felt that prices were going to be higher in the future. The same shift would have happened if personal income taxes were reduced. So if the value of their assets or their income changes. the AD would shift from AD to AD1. If consumers spend more. One example will explain. the AD will shift to the right to point D. or the government increases its spending. the quantity of aggregate demand changes as the price level changes. If the USD were depreciating.AD4 (0) Explain how the foreign purchases effect would work if the price level in Alpha decreased. When people feel wealthier. or stock market assets were increasing. In other words. AD shifts. I. But the AD curve can shift because of exogenous variables. Suppose the economy is at point B. So any change in C. business increase their investment.

AD5 (0) Event PL (U or D) Personal income taxes decrease Consumer confidence spurs increased spending Housing values skyrockets Businesses become pessimistic about the future The USD rapidly appreciates because of higher domestic interest rates Government slashes military spending iPods become the rage around the world. 3. Domestic exports increase The money supply increases along with consumption The government pursues contractionary Fiscal Policy A lower reserve ratio spurs more lending to business. S. WhilWind Workbooks Pantent Pending 4 . 17. Investment increases U. 11. 4. goods suddenly become attractive to foreigners Businesses become optimistic about future sales Foreign income increases Business taxes increases. 12. 9. 10. 5. 15. 6. 18. Businesses expect lower profits Consumer spending on durables declines USD appreciates relative to foreign currencies Personal income taxes decline Wealth increases because of higher stock market values AD (U or D) Real GDP (U or D) 1. 16. 2. 8. 13. 7. 14.

The government pursues contractionary Fiscal Policy 10. Consumer confidence spurs increased spending 3. Net exports would increase. Domestic exports increase 8.000 AD4 The USD would appreciate as more US goods would be demanded by foreigners. The USD rapidly appreciates because of higher domestic interest rates 6. Housing values skyrockets 4.62% AD3 The interest is: $400.37 Up Down Up Up Down Up Up U Right D Left U Right U Right D Left U Right U Right Up Down Up Up Down Up Up WhilWind Workbooks Pantent Pending 5 . AD would shift to the right. Investment increases 11. S. Government slashes military spending 7. goods suddenly become attractive to foreigners PL (U or D) Up Up Up AD (U or D) Real GDP (U or D) U Right Up U Right Up U Right Up Real Balance 18750 16666. Event 1. iPods become the rage around the world. Personal income taxes decrease 2. U. A lower reserve ratio spurs more lending to business. Businesses become pessimistic about the future 5.Solutions AD1 Price Level 80 90 100 110 AD2 The inflation rate is 1. The money supply increases along with consumption 9.67 15000 13636.

Consumer spending on durables declines 16. Businesses become optimistic about future sales 13.12. Wealth increases because of higher stock market values Up Up Down Down Up Up Up U Right U Right D Left D Left U Right U Right U Right Up Up Down Down Up Up Up WhilWind Workbooks Pantent Pending 6 . USD appreciates relative to foreign currencies 17. Personal income taxes decline 18. Foreign income increases 14. Business taxes increases. Businesses expect lower profits 15.

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