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LOS b: Explain the components of and the factors that affect real GDP demanded, describe the aggregate demand curve and why it slopes downward, and explain the factors that can change aggregate demand.

A)	decrease investment and increase net exports.

B)	decrease investment and decrease consumption.

C)	increase government spending and decrease consumption.

An increase in interest rates can be expected to decrease business investment and decrease consumption. The impact on government spending and net exports is not clear-cut.

Which of the following is NOT a reason that the aggregate demand curve slopes downward?

A)	Because entitlements are adjusted for inflation, a rising price level forces government spending to increase.

B)	The wealth effect causes consumers to spend less when the price level rises.

C)	Business investment declines as a rising price level increases interest rates.

The aggregate demand curve plots real GDP against the price level. Rising entitlement payments that result from an increasing price level affect nominal GDP, but not real GDP. Both remaining choices describe reasons why the consumption and investment components of real GDP decrease when the price level increases.

Which of the following statements concerning aggregate demand is most accurate?

A)	When price levels rise, real wealth increases, and individuals will spend more.

B)	When price levels fall, real wealth increases, and individuals will spend less.

C)	When price levels rise, real wealth decreases, and individuals will spend less.

When price levels rise, real wealth decreases, and we would expect individuals to spend less. If the converse were also true—if price levels were to fall—real wealth should increase, and we would expect individuals to spend more, all else being equal.

Which of the following least accurately describes a component of aggregate demand?

The components of aggregate demand are consumption, investment, government spending, and net exports, which is exports minus imports.

An increase in the expected rate of inflation is most likely to cause aggregate demand and short-run aggregate supply to:

Increasing inflation expectations lead to higher money wage rates, which causes a decrease in short-run aggregate supply (SAS curve shifts to the left). Higher expected inflation will also encourage consumers to make purchases sooner than they otherwise would have, which increases aggregate demand (shifts the AD curve to the right).

When incomes in foreign countries increase, aggregate demand in the U.S. is most likely to:

A)	decrease because U.S. interest rates will tend to increase.

B)	decrease because foreign consumers will tend to buy fewer U.S. export goods.

C)	increase because foreign consumers will tend to buy more U.S. export goods.

When incomes in foreign countries increase, it is unlikely to have a direct effect on interest rates in the U.S. However, increased foreign income is likely to result in greater foreign purchases of U.S. exports. Thus, aggregate demand in the U.S. is likely to increase.

Which of the following choices best describes the effects on consumption, investment, and net exports that would result from an increase in the price level, other factors held constant?

Decrease

Increase

Decrease

At higher price levels, consumption, investment, and net exports all decrease. A rising price level decreases consumers’ real wealth, so they consume less. The higher price level will increase interest rates, which causes business investment to decrease. Rising domestic prices will also reduce foreign purchases of the country’s goods, decreasing net exports.

Which of the following is most likely to occur in the short run if there is an unanticipated decrease in aggregate demand due to a reduction in business and consumer optimism?

A)	An increase in the rate of unemployment.

B)	A higher rate of inflation.

C)	An increase in real GDP.

If business and consumer optimism wanes, consumers will spend less and defer current consumption and save more of their disposable income. With reduced product demand, businesses will reduce their capital expenditures and investments. These actions will lead businesses to reduce their number of employees, thereby increasing the rate of unemployment. Moreover, current output will decrease and the price level will fall.

Patch Grove Analytics is evaluating candidates for an economic analyst internship. To demonstrate his grasp of the effects of consumer behavior on aggregate demand, a candidate makes the following statements during his interview:

Statement 1: The wealth effect occurs when consumers feel wealthier at higher price levels because their wages will also increase, and spend more in the current period as a result.

Statement 2: Intertemporal substitution accounts for consumers’ tendency to increase their planned purchases in the current period and decrease planned future purchases when interest rates increase.

Both statements are incorrect. The wealth effect causes real consumption spending to decrease at higher price levels because consumers have less wealth in real terms, and consequently spend less. When interest rates increase, consumers spend less in the current period as they delay purchases until future periods. They substitute purchases later for purchases now (intertemporal substitution).

A)	An increase in real wealth.

B)	Increasing real interest rates.

C)	An expected decrease in future prices.

While an increase in real wealth will shift the AD curve to the right, an increase in the real rate of interest will shift the AD curve to the left as consumers and businesses reduce their borrowing and spending. An expected decrease in prices will shift the AD curve to the left as households and businesses postpone their consumption in anticipation of lower prices in the future.