Figure 14-3
Panel (a) Panel (b)
-Refer to Figure 14-3. Suppose the interest rate rises from 4.8% to 6% as shown in Panel (a) and the quantity of investment demanded falls from I_a to I_b. As a result of this, in Panel (b) ,

Question

Figure 14-3
Panel (a) Panel (b)

-Refer to Figure 14-3. Suppose the interest rate rises from 4.8% to 6% as shown in Panel (a) and the quantity of investment demanded falls from I_a to I_b. As a result of this, in Panel (b) ,

Quizplus · Accepted Answer

An increase in interest rates decreases investment demand, which leads to a decrease in aggregate demand. This is represented by a leftward shift in the IS curve. However, the effect on the aggregate demand curve depends on the slope of the aggregate supply curve. If the aggregate supply curve is steep (i.e., relatively inelastic), then the decrease in aggregate demand will translate into a larger decrease in real output and a smaller increase in the price level. This is represented by a leftward shift in the aggregate demand curve. If the aggregate supply curve is relatively flat (i.e., elastic), then the decrease in aggregate demand will translate into a smaller decrease in real output and a larger increase in the price level. This is represented by a movement up along the aggregate demand curve. In the absence of information about the slope of the aggregate supply curve, it is impossible to determine whether the aggregate demand curve will shift or there will be a movement up along the prevailing aggregate demand curve. However, given the answer choices, the closest option is B, which says that the aggregate demand curve shifts from AD₂ to AD₁, implying that the aggregate supply curve is relatively steep.