Question

Aggregate demand curve 

The following graph shows the aggregate demand curve in a hypothetical economy. Assume that the economy's money supply remains fixed. 

Which of the following are reasons the aggregate demand curve is downward sloping? Check all that apply. 

A lower price level leads to a lower interest rate. 

A higher price level makes domestically produced goods more expensive than foreign goods. 

A lower price level increases consumption through the income effect. 

As the aggregate price level rises, the purchasing power of households' saving balances will _______  causing the quantity of output demanded to _______ . This phenomenon is known as the _______  effect.

Answer 1

All the three statements are correct.

Reason-

A lower price level leads to a lower interest rate.

- This is the interest rate effect. Price falls, cost of investment falls, demand rises.

A higher price level makes domestically produced goods more expensive than foreign goods.

- This is the exchange rate effect. Price level rises, real exchange rate appreciate, net exports decreases, Aggregate demand falls.

A lower price level increases consumption through the income effect.

-This is the income effect. When pice level falls, consumption is cheaper, it rises, aggregate demand rises.

As the aggregate price level rises, the purchasing power of households' saving balances FALL will causing the quantity of output demanded to FALL . This phenomenon is known as the WEALTH effect.

Reason- When the price level rises, purchasing power of savings fall, household cannot puchase the same amount now as price has increased. Demand falls. It is known as wealth effect.