Determine how the following affect the slope of the output demand curve, and exp
ID: 1097169 • Letter: D
Question
Determine how the following affect the slope of the output demand curve, and explain your result. A) The marginal propensity to consume increases. B) The inter temporal substitution effect of the real interest rate on current consumption increases. C) The demand for investment goods becomes less responsive to the real interest rate. Determine how the following affect the slope of the output demand curve, and explain your result. A) The marginal propensity to consume increases. B) The inter temporal substitution effect of the real interest rate on current consumption increases. C) The demand for investment goods becomes less responsive to the real interest rate. A) The marginal propensity to consume increases. B) The inter temporal substitution effect of the real interest rate on current consumption increases. C) The demand for investment goods becomes less responsive to the real interest rate.Explanation / Answer
a. Increase in the marginal propensity to consume will cause the aggregate demand to be steeper. This is because, in Keynesian cross, when MPC increases, multiplier also increases; as a result, small change in any exogenous variable will cause output to increase many folds.
b. Intertemporal substitution effect implies, the rise in the price level, other things remaining the same, decreases the value of money and raises the interest rate. Faced with higher interest rate, people will borrow less and consume less, as a result GDP decreases.
Therefore, when consumption increases, the inetetemporal substitution effect will depend on the real interest rate. If with the increase consumption also increases price which in turn raises interest rate, then the opportunity cost of buying today will increase, so people will decreases consumption and hence GDP will decreases. So the slop of AD will depend on the price, if price is high the slop of AD will be low, and hence the output.
c. When the demand for investment goods have less responsive to the real interest rate, the output demand curve will have low slop. So that when demand increases output only increase by less proportion.
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