AS Level Economics 9708: Interest Rates, Aggregate Demand and Short-Run Equilibrium

Halvern's central bank unexpectedly cuts its base interest rate from 6% to 3%, making it significantly cheaper for households and firms to borrow.

(a) State the equation for Aggregate Demand (AD) in terms of its four components, and identify which component(s) of AD are most directly affected by a cut in the interest rate. [3]

(b) Explain why this interest-rate cut causes a shift of Halvern's AD curve, rather than a movement along it, and state the direction of the shift. [3]

(c) Halvern's short-run aggregate supply (SRAS) curve is upward sloping. Describe, using the AD/AS model, the effect of the shift you identified in (b) on Halvern's equilibrium price level and level of real output in the short run. [3]

Part (a): The AD equation and the components affected

Aggregate Demand is the total planned spending on an economy’s output at a given price level:

$AD = C + I + G + (X - M)$

where $C$ is consumption, $I$ is investment, $G$ is government spending, $X$ is exports and $M$ is imports.

A cut in the interest rate most directly affects:

Consumption (C): borrowing to fund spending (for example on cars or furniture) becomes cheaper, and the reward for saving instead of spending falls, so households are encouraged to spend more of their income now.
Investment (I): the cost of borrowing to finance new capital projects falls, so more investment projects that were previously unprofitable at the higher interest rate now become profitable, encouraging firms to invest more.

Part (b): Shift, not movement - and its direction

A movement along the AD curve happens only when Halvern’s own price level changes. A shift of the AD curve happens when a non-price determinant of AD changes instead, altering the amount of AD at every price level. The interest rate is exactly this kind of non-price determinant: it changes the cost of borrowing and the reward for saving, not Halvern’s price level directly.

Since the interest-rate cut raises both consumption and investment at every possible price level, Halvern’s AD curve shifts to the right (AD increases).

Part (c): Effect on short-run equilibrium price level and real output

Halvern’s SRAS curve is upward sloping: firms are willing to supply more output only at a higher price level, since costs tend to rise as firms use resources more intensively.

With SRAS unchanged and AD shifting right:

The new equilibrium is found where the new (higher) AD curve intersects the unchanged, upward-sloping SRAS curve.
Moving up along the SRAS curve to reach this new intersection point means both the equilibrium price level rises and the equilibrium level of real output rises, compared with the position before the interest-rate cut.

Intuitively, firms respond to the extra demand from cheaper consumption and investment spending by producing more output, but since SRAS slopes upward, meeting this extra demand also requires firms to accept or pass on higher costs, so prices rise at the same time as output does.

Final answers

(a) $AD = C+I+G+(X-M)$ ; the interest-rate cut most directly affects consumption (C) and investment (I).
(b) A shift (not a movement) of the AD curve, rightward, since the interest rate is a non-price determinant of AD.
(c) With SRAS upward sloping, both the equilibrium price level and equilibrium real output rise in the short run.