Chapter 8 Aggregate Demand and Aggregate Supply

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Why the Aggregate-Demand Curve Slopes Downward

Recall that GDP (Y ) is made up of four components: consumption (C ), investment (I ), government purchases (G ), and net exports (NX ).

Each of the four components is a part of aggregate demand.

Government purchases are assumed to be fixed by policy. 

This means that to understand why the aggregate-demand curve slopes downward, we must understand how changes in the price level affect consumption, investment, and net exports.

(1) The Price Level and Consumption: The Wealth Effect

Consider the money in your pocket and in your bank account.

When the price level rises, the nominal value of this money is unchanged. 

However, each dollar now can buy fewer goods, thus the real value of money declines and people feel poorer which in turn reduces consumer spending.

The decrease in consumer spending means a decrease in the quantity of goods and services demanded.

The effect of the price level on consumption spending is named wealth effect.

This effect works in reverse, too:

A decrease in the price level raises the real value of money and makes consumers feel wealthier, which in turn encourages them to spend more.

The increase in consumer spending means a larger quantity of goods and services demanded.

(2) The Price Level and Investment: The Interest-Rate Effect

When the price level rises, buying g&s requires more dollars. Assume people want to maintain their shopping lists. 

To get the extra dollars, people sell bonds, stocks or other assets. 

This would reduce the saving and increase interest rate.

A higher interest rate will discourage the investment spending，and therefore decreases the quantity of goods and services demanded.

The effect of the price level on investment spending is named interest rate effect.

The interest-rate effect also works in reverse:

When the price level decreases, people need to hold less money to buy the goods and services they usually consume.

Hence, households try to reduce their holdings of money by lending some out and this would increase the supply of loanable funds in the financial market.

Therefore, the interest rate will drop which encourage firms to borrow more to invest in capital goods and encourage households to borrow more to to invest in new housing. 

Thus, a lower price level reduces the interest rate, encourages greater spending on investment goods, and therefore increases the quantity of goods and services demanded.

(3) The Price Level and Net Exports: The Exchange-Rate Effect

When the U.S. price level rises and causes U.S. interest rates to rise, foreign investors will seek higher returns by investing in U.S. assets.

This would result in higher demand for U.S. dollars in foreign exchange market, thus leading to dollar's appreciation.

This appreciation of dollar makes foreign goods relatively cheaper to U.S. residents and encourages U.S. import more foreign goods. 

While, an appreciation of dollar makes U.S. goods more expensive to foreign residents and reduces U.S. export goods to foreigners.

Therefore, U.S. net exports falls and thereby the quantity of goods and services demanded by foreigners decreases.

The effect of the price level on net exports is named the exchange rate effect.

Again, the exchange-rate effect also works in reverse: 

A lower price level in the United States lowers the U.S. interest rate.

American investors will seek higher returns by investing abroad, thus raising the supply of dollars in foreign exchange market and causing dollars to depreciate.

Due to depreciation of dollar, U.S. goods become relatively cheaper to foreign goods. Exports rise, imports fall, and net exports increase.

Therefore, when a fall in the U.S. price level causes U.S. interest rates to fall, the real exchange rate depreciates, and U.S. net exports rise, thereby increasing the quantity of goods and services demanded.

To summarize, when the price level rises, decreased wealth depresses consumer spending, higher interest rates depress investment spending, and a currency appreciation depresses net exports.

All three of these effects imply that, all else being equal, there is an inverse relationship between the price level and the quantity of goods and services demanded.