Q17 April 2013

[dextar]

Hi
Which of the following will result in a decrease in aggregate demand for an economy
with international trade, other things being equal?
A A rise in imports
B A fall in savings
C A fall in interest rates
D A fall in economic and business uncertainty

Again i'm failing in chapter 16 . I think it is testing that only
my reasoning is if AD has to decrease then the domestic currency has to depreciate and international one has to appreciate.
Some of the reasons mentioned in the material is
Possible causes of depreciation includes
a fal in domestic interest rate
higher inflation
rise in domestic income and increasing import

Answer is A but why not C ?

 

[Margaret Wood]

For this question, you just have to know what aggregate demand is, ie C+I+G+X-M.

If imports (M) increase, AggD will fall (people are buying foreign goods rather than domestic goods) so this is the answer.
If savings fall, consumption (C) will increase and therefore AggD will increase.
If interest rates fall, C and investment (I) will increase (lower cost of borrowing will encourage borrowing to buy cars, machinery etc) so AggD will increase.
If uncertainty decreases, C and I will increase (as consumers and firms feel more confident about their future incomes) so AggD will increase.

 

[dextar]

Thank you so much for answering Margaret.
I have one more question
AD=C+I+G+NX this implies that AD has nothing to do with interest rates or vice versa it is the AS that depends on interest rates and other features. Correct?

 

[Margaret Wood]

Hi Dextar

Aggregate demand = C + I + G + (X-M). It is the sum of all the demand for the economy's goods and services from consumers, firms, government and foreigners.

It is therefore affected by anything that affects its components, including interest rates. For example, if interest rates increase:

(1) it will be more expensive to borrow, so consumption and investment will fall.
(2)foreigners will want to move their savings to this country, so there will be an increase in the demand for the currency and the currency will increase in value, thus making exports (X) more expensive and imports (M) cheaper, causing X to decrease and imports increase.

An increase in interest rates will therefore cause a decrease in AggD.

Other factors that affect AggD include taxation (eg an increase in income tax will decrease C); business confidence (affects investment); government spending; tariffs on imports.

Aggregate supply is the total output produced. This is affected by the quantity and quality of the factors of production, technological progress and efficiency. Supply-side policies, eg education and training, aim to increase aggregate supply.

 

[dextar]

Thanks a lot Madam for your detailed explanation