What impact do the following have on the aggregate demand curve? Give suitable examples to support your answers

Question

a. The Wealth Effect
b. The Interest Rate Effect
c. The Exchange Rate Effect

Answer 1

a. The Wealth Effect: The aggregate demand curve is drawn assuming a fixed amount of wealth. As the price level changes, the purchasing power of wealth has varying effects on the level of consumption spending. For example, if prices fall, a fixed level of wealth will purchase more, consumption will increase, and aggregate quantity demanded will increase. If prices rise, a household's wealth will buy less, and aggregate quantity demanded will decrease.
b. Interest Rate Effect: As the price level falls, buyers require less money for their purchases, and the demand for money falls. A decrease in the demand for money results in a decrease in the interest rate, and interest-sensitive purchases, such as cars, houses, and business investments, increase.
c. The Exchange Rate Effect: As noted earlier, interest rates fall in response to a decrease in the price level. For example, if the overall U.S. price level falls, U.S. interest rates decrease. A decline in U.S. interest rates causes the U.S. dollar to depreciate in foreign exchange markets, making U.S. exports more attractive and imports less attractive. As a result, exports increase, imports decrease, and net exports (EX – IM) increase, resulting in an increase in aggregate quantity demanded. As the price level increases, interest rates increase, the U.S. dollar appreciates, net exports decline, and aggregate quantity demanded decreases.