Question

When financial frictions increase, the real cost of borrowing ____, and the AD curve ____.

A. increases, shifts left

B. decreases, shifts right

C. increases, shifts right

D. decreases, shifts left

When inflation increases, the AD curve _____. (What way does the AD curve shift or does it not shift?)

Answer 1

Answer: A. increases, shifts left

When financial frictions increase, the real cost of borrowing increases, and the AD curve shifts left.

During the financial friction, the real cost of borrowing capital increases. As a result, the investment demand for capital decreases. The decrease in investment decreases the aggregate demand in the economy. So the aggregate demand(AD) curve shifts leftward.

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When inflation increases, the AD curve shifts leftward.

The increase in inflation decreases the purchasing power of people as the value of money decreases. So the real consumption spending decreases with the increase in inflation. As the real consumption spending decreases, the aggregate demand in the economy decreases. The decrease in aggregate demand shifts the aggregate demand(AD) curve leftward. So the decrease in real consumption spending is the reason of the shift of the AD curve leftward.

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