It means the prices people receive—their wages, the rents they may charge as landlords, the interest rates they earn—are likely to be falling as well. A falling price level means that goods and services are cheaper, but incomes are lower, too. There is no reason to expect that a change in real income will boost the quantity of goods and services demanded—indeed, no change in real income would occur. Why, then, does the aggregate demand curve slope downward?
One reason for the downward slope of the aggregate demand curve lies in the relationship between real wealth the stocks, bonds, and other assets that people have accumulated and consumption one of the four components of aggregate demand.
When the price level falls, the real value of wealth increases—it packs more purchasing power. An increase in wealth will induce people to increase their consumption. The consumption component of aggregate demand will thus be greater at lower price levels than at higher price levels.
The tendency for a change in the price level to affect real wealth and thus alter consumption is called the wealth effect; it suggests a negative relationship between the price level and the real value of consumption spending.
A second reason the aggregate demand curve slopes downward lies in the relationship between interest rates and investment. A lower price level lowers the demand for money, because less money is required to buy a given quantity of goods. What economists mean by money demand will be explained in more detail in a later chapter. But, as we learned in studying demand and supply, a reduction in the demand for something, all other things unchanged, lowers its price.
A lower price level thus reduces interest rates. Lower interest rates make borrowing by firms to build factories or buy equipment and other capital more attractive. A lower interest rate means lower mortgage payments, which tends to increase investment in residential houses. Investment thus rises when the price level falls. The tendency for a change in the price level to affect the interest rate and thus to affect the quantity of investment demanded is called the interest rate effect.
John Maynard Keynes, a British economist whose analysis of the Great Depression and what to do about it led to the birth of modern macroeconomics, emphasized this effect. For this reason, the interest rate effect is sometimes called the Keynes effect. A third reason for the rise in the total quantity of goods and services demanded as the price level falls can be found in changes in the net export component of aggregate demand.
All other things unchanged, a lower price level in an economy reduces the prices of its goods and services relative to foreign-produced goods and services. The result is an increase in net exports. The international trade effect is the tendency for a change in the price level to affect net exports. Taken together, then, a fall in the price level means that the quantities of consumption, investment, and net export components of aggregate demand may all rise.
Since government purchases are determined through a political process, we assume there is no causal link between the price level and the real volume of government purchases. Therefore, this component of GDP does not contribute to the downward slope of the curve. In general, a change in the price level, with all other determinants of aggregate demand unchanged, causes a movement along the aggregate demand curve. A movement along an aggregate demand curve is a change in the aggregate quantity of goods and services demanded.
A movement from point A to point B on the aggregate demand curve in Figure 7. Such a change is a response to a change in the price level. Notice that the axes of the aggregate demand curve graph are drawn with a break near the origin to remind us that the plotted values reflect a relatively narrow range of changes in real GDP and the price level. We do not know what might happen if the price level or output for an entire economy approached zero.
Such a phenomenon has never been observed. Aggregate demand changes in response to a change in any of its components. An increase in the total quantity of consumer goods and services demanded at every price level, for example, would shift the aggregate demand curve to the right. A change in the aggregate quantity of goods and services demanded at every price level is a change in aggregate demand , which shifts the aggregate demand curve.
Increases and decreases in aggregate demand are shown in Figure 7. Changes in Aggregate Demand. An increase in consumption, investment, government purchases, or net exports shifts the aggregate demand curve AD1 to the right as shown in Panel a. A reduction in one of the components of aggregate demand shifts the curve to the left, as shown in Panel b.
What factors might cause the aggregate demand curve to shift? Each of the components of aggregate demand is a possible aggregate demand shifter. We shall look at some of the events that can trigger changes in the components of aggregate demand and thus shift the aggregate demand curve.
Several events could change the quantity of consumption at each price level and thus shift aggregate demand. One determinant of consumption is consumer confidence. If consumers expect good economic conditions and are optimistic about their economic prospects, they are more likely to buy major items such as cars or furniture.
The result would be an increase in the real value of consumption at each price level and an increase in aggregate demand. In the second half of the s, sustained economic growth and low unemployment fueled high expectations and consumer optimism.
Surveys revealed consumer confidence to be very high. All 4 GPD components contribute to the aggregate demand for goods and services. The other three components of spending are—consumption, investment, and net exports—depend on economic conditions and, in particular, at the price level. To read why the downward slope of the aggregate-demand curve, therefore, we must examine how the price level affects the quantity of goods and services demanded consumption, investment, and net exports.
There are three essential theories why economists believe that there is a downward sloping aggregate demand curve. Thus, a decrease in the price level makes consumers feel wealthier, which in turn encourages them to spend more money. Similarly, if for any reason people woke up the next morning, and the price of everything was to double. Everything will be expensive. People will have to buy less of everything.
Moreover, demand fewer goods and service. The price level is one factor of the quantity of money demanded. The cheaper the price level, the fewer money households need to hold to buy the goods and services they want. When the price level falls, therefore, households try to reduce their holdings of money by lending some of it out. For instance, a household might use its excess money to buy interest-bearing bonds.
Alternatively, it might deposit its excess cash in an interest-bearing savings account, and the bank would use these funds to make more loans. In either case, as households try to convert some of their money into interest-bearing assets, they drive down interest rates. Lower interest rates, in turn, encourage borrowing by firms that want to invest in new plants and equipment and by households who wish to invest in new housing. Thus, a lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the number of products and services demanded.
Any situation that changes net exports for a given price level also shifts aggregate demand. The increased demand for a fixed supply of money causes the price of money, the interest rate , to rise. As the interest rate rises, spending that is sensitive to rate of interest will decline. Hence, the interest rate effect provides another reason for the inverse relationship between the price level and the demand for real GDP. The third and final reason is the net exports effect.
Changes in aggregate demand. Changes in aggregate demand are represented by shifts of the aggregate demand curve. An illustration of the two ways in which the aggregate demand curve can shift is provided in Figure.
A shift to the right of the aggregate demand curve. A shift to the left of the aggregate demand curve, from AD 1 to AD 3 , means that at the same price levels the quantity demanded of real GDP has decreased.
Changes in aggregate demand are not caused by changes in the price level. Instead, they are caused by changes in the demand for any of the components of real GDP, changes in the demand for consumption goods and services, changes in investment spending, changes in the government's demand for goods and services, or changes in the demand for net exports. Consider several examples. Suppose consumers were to decrease their spending on all goods and services, perhaps as a result of a recession.
Then, the aggregate demand curve would shift to the left. Suppose interest rates were to fall so that investors increased their investment spending; the aggregate demand curve would shift to the right.
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