Question

Explain how each of the following affects the shape and position of the AD curve.

a) an increase in the real money supply

b) an increase in the nominal money supply

c) an increase in the multiplier

Answer 1

Aggregate demand curve shows the relation between price and aggregate expenditure in the economy. It shows the real output that consumers in an economy desire to buy at given price level. The curve is downward sloping because at lower prices, people are able to buy more of a good and at higher prices, the purchasing power falls and they buy less of the goods.

a) An increase in real money supply does not alter the position of AD curve because an increase in the real money supply means an increase in nominal money supply M and an increase in prices P. Increase in M motivates the individual to spend more but an increase in P discourage them from spending. Hence, overall there is no change in AD for the economy.

b)  An increase in the nominal money supply shifts the AD curve to right. This is because an increase in nominal money supply causes interest rates to fall (in the money market) and this fall in interest rates induce increase in investments. As investments rise, AD in the economy rises shifting the AD to right.

c) An increase in multiplier increases the income/output of individuals in the economy by a larger amount. This higher income induces people to spend more. Higher spending shifts the AD to right. Therefore, higher multiplier shifts the AD rightwards