Question

For each of the following, explain whether aggregate demand of a country will be affected

and how (increase, decrease, no change). Explain also the effect on the trade balance.

(a) Increase in consumer confidence

(b) Decrease in technology

(c) Depreciation of the real exchange rate

Answer 1

At any given point in time, the aggregate demand (AD) is defined as a sum of consumption demand, investment demand, government spending and net exports.

(a) Increase in consumer confidence

An increase in consumer confidence will result in a greater consumer spending now as they have good outlook about the economy. Hence, it will increase the aggregate demand of a country at a given point in time.

(b) Decrease in technology
This affects only the Aggregate Supply of the economy. Hence there will be no change in the aggregate demand of a country.

(c) Depreciation of the real exchange rate
A Depreciation of the real exchange rate implies that the domestic currency becomes relatively cheaper than foreign currency. Note that exchange rate is the price of a currency in terms of a foreign currency. A cheaper domestic currency implies that domestic goods will become cheaper relative to foreign goods. Hence the aggregate demand will increase as net exports will increase.