Suggested Answers of BT2 Revision Package - ASKnLearn

Besides the above, an increase in the interest rate can also cause government expenditureto fall. In addition, the excessive strengthening of the exchange rate due to the huge capitalinflow can also cause net exports to fall.MEC / interest rate R 2 Fig. 1: Impact of an increase in interest rate on investment R 1 MEI O I 2 I 1 investment With reference to Figure 2, given a fall in the components of AE due to an increase ininterest rate, the AE function shifts down from AE 0 to AE 1. At this level of output Y 0, the levelof output produced is more than AE. Hence, there is a piling up of inventories and will signalto the producers to lower production. This lower production will mean less factors ofproduction will be used, hence leading to a lower circular flow of income and expenditure.AE AE 0 AE 1 Y 1 Y 0 NY Figure 2: Impact of a fall in AE