3.2 Variations in economic activity - aggregate demand and aggregate supply

The question asks about the wealth effect — one of three reasons the AD curve slopes downward. The wealth effect links a change in the price level to a change in the real value of fixed-nominal-value assets held by households.

The bank deposits have a fixed nominal value of $30,000.Whenthepricelevelfalls,the\ast \ast realpurchasingpower\ast \ast ofthose$30,000 rises — the same nominal sum buys more goods and services than before. The household perceives itself as wealthier in real terms.

Feeling wealthier, the household increases consumption (C). Since AD = C + I + G + (X − M), higher C raises the real GDP demanded at this lower price level. This is triggered by a change in the price level itself.

Because the cause is a change in the price level (the variable on the vertical axis of the AD diagram), this produces a movement along the existing AD curve — not a shift of the whole curve. The curve itself has not moved; we have simply traced out a lower point on it.

The question tests two sub-concepts simultaneously: (1) whether nominal or real value changes, and (2) whether the outcome is a shift of AD or a movement along it.

'The nominal value of the deposits rises' is incorrect — bank deposits have a fixed nominal value. The price level falling does not change the $30,000 figure. This eliminates option A and option D on the same grounds.

Option C states the curve shifts rightward. A shift of AD occurs only when a non-price determinant of C, I, G or (X−M) changes. Here, the trigger is a change in the price level itself, so the correct description is a movement along the curve, not a shift. Option C is therefore incorrect.

Option B correctly states that the real purchasing power of the deposits rises, that consumption increases as a result, and that this represents a movement down along the AD curve — precisely because a price-level change is the trigger, not a non-price determinant.

The interest rate effect is one of three reasons the AD curve slopes downward. It works through the demand for money: when the price level falls, everyday transactions cost less, so households and firms need to hold less money.

With the money supply unchanged, a fall in money demand reduces the equilibrium interest rate — the 'price' of borrowing. This makes credit cheaper for both firms (reducing the cost of financing capital projects) and households (reducing the cost of mortgages and consumer loans).

Cheaper borrowing raises investment (I) by firms and interest-sensitive consumption (C) by households. Because both I and C are components of $AD=C+I+G+(X-M)$, the quantity of real GDP demanded rises at this lower price level — a movement along the AD curve.

The correct answer identifies the money-demand channel (less need to hold cash for transactions → lower interest rates) and correctly links it to higher I and C, without confusing it with the wealth effect or the exchange rate effect.

The question asks specifically about the interest rate effect. The other two downward-slope explanations — wealth effect and exchange rate effect — and a supply-side distractor appear as options.

'Lower prices raise the real value of savings, making households feel wealthier' describes the wealth effect, not the interest rate effect. This is option A and can be eliminated.

'Lower prices make domestic exports cheaper relative to imports, raising net exports' describes the exchange rate effect. This is option C and can be eliminated.

'Lower prices reduce firms' production costs, raising profit margins' describes a movement along the SRAS curve — this is a supply-side concept, not a reason AD slopes downward. Option D is eliminated.

Option B correctly traces the interest rate effect: lower price level → lower transactions demand for money → lower interest rates → higher I and C → higher quantity of real GDP demanded.

A currency depreciation changes the relative price of domestically produced goods versus foreign goods. This directly affects the net exports component: $X-M$ in $AD=C+I+G+(X-M)$.

With a depreciation, domestically produced goods become cheaper in foreign-currency terms, so foreign buyers demand more exports ($X$ rises). Simultaneously, foreign goods become more expensive in domestic-currency terms, so domestic buyers substitute away from imports ($M$ falls).

Both effects raise $(X-M)$. Since this is a change in a non-price determinant of net exports (the exchange rate changed independently of the domestic price level), it shifts the entire AD curve rightward.

Option B correctly identifies net exports as the directly affected component and the rightward AD shift. This is distinct from the exchange rate effect (which explains the AD slope); here, an actual currency movement shifts the whole curve.

The question has two parts — which AD component is most directly affected, and does the AD curve shift left or right? Evaluate each option on both criteria.

Option A claims G increases. Government spending is determined by fiscal policy decisions, the economic cycle, and political priorities — not directly by currency depreciation. Eliminating option A.

Option C claims AD shifts leftward because imports become dearer, reducing consumption. While import prices do rise, this is only part of the story — it ignores the simultaneous rise in X and fall in M, and the net effect is a rise in (X−M), not a fall in overall AD. Eliminating option C.

Option D claims the depreciation lowers domestic interest rates and raises I. This confuses a currency depreciation with a monetary policy action. Depreciation does not automatically lower interest rates. Eliminating option D.

Option B is correct: depreciation raises X and lowers M, increasing (X−M) and shifting AD rightward at every price level.