Question

10. Suppose that consumer spending initially rises by 7 billion for every 1 percent rise in household wealth and that investment spending initially rises (or falls) by 20 billion for every percentage point fall (rise) in the real interest rate. Also, assume the economy's multiplier is 5. a. If household wealth rises by 5% and the real interest rate increases by 1%, by how much would aggregate demand initially shift at each price level? By how much and in which direction would it eventually shift? Direction: Amount:

Answer 1

For 1 percent increase in wealth of household, consumption increases by 7 billion. For 1 percent increase in rate of interest, investment spending falls by 20 billion. Multiplier is 5

a) Now wealth rises by 5% so consumption increases by 7 billion x 5% / 1% = 35 billion. Also interest rate increases by 1 percent so investment spending falls by 20 billion. This shows that aggregate spending / expenditure would actually increase by (35 billion - 20 billion) = 15 billion. AD initially shift by 15 billion

b) Eventually, it shifts to the right by 15 x 5 = 75 billion. (5 is the multiplier).