Aggregate Demand

Aggregate Demand (AD) represents the quantity of goods and services that households, businesses, and government and international customers want to buy at any given level of prices. 

Aggregate Supply (AS) represents the quantity of goods and services that producers are willing to supply at any given level of prices. It also reflects the amount of labor and capital households are willing to offer into the marketplace at given real wage rates and the cost of capital. 

Aggregate Demand

Under the aggregate demand curve, the quantity demanded increases as the price level declines because lower prices allow us to buy more goods within a given level of income. However, since income is not fixed in this case, aggregate income/expenditure (GDP) is determined within the model along with the price level. 

The aggregate demand curve represents the combinations of aggregate income and the price level at which two conditions are satisfied; aggregate expenditure equals aggregate income, and households and businesses willingly hold the available real money supply.

The downward slope of the aggregate demand curve results from three effects: the wealth effect, the interest rate effect, and the real exchange rate effect.

The Wealth Effect

The wealth effect is based on the concept of purchasing power of nominal wealth, including the nominal value of the money held by consumers, physically or in a bank account. Unlike the nominal value, the real value in terms of goods and services is not fixed and fluctuates with the prices of goods and services. 

If one loaf of bread costs 1 USD and we have 5 USD, then the real money holdings are 5 loaves of bread. If the price of bread increases to 2 USD, the 5 USD is now worth 2 loaves of bread. Our real money holdings and real wealth have decreased. As the real value of money holdings changes, so does the real wealth. 

The wealth effect is one reason that the aggregate demand curve is downward sloping. When the price rises, the number of products and services that can be purchased with a fixed amount of nominal wealth decreases—consumers are less wealthy (in real terms) and hence desire fewer goods and services.

The Interest Rate Effect

When the price level fluctuates, so does the demand for money. If bread is 2 USD and we have 2 USD, we can have a loaf of bread. However, if the price of bread increases to 4 USD, then if we want to continue consuming bread, then we will need 4 USD. 

With a fixed supply of money, the price of money increases. Because the price of money is the interest rate, then as the price level increases, the interest rate increases. Additionally, holding money in liquid form means we are giving up the interest we could earn by lending the money out. Therefore, when price levels decrease, we will want to put more money in interest bearing assets. 

Interest rate changes have an impact on the quantity of products and services demanded. Businesses invest less when interest rates rise because their borrowing costs rise. Furthermore, higher interest rates result in less consumption. If interest rates fall, firms will be able to invest in more profitable projects, and consumers will spend more.

The Real Exchange Rate Effect

An increase in the domestic price level causes an appreciation of the real exchange rate. A greater price level influences the actual exchange rate and raises the cost of domestic goods in foreign countries, limiting exports. This also makes non-domestic goods less expensive domestically, increasing imports. 

This dynamic gives us the real exchange rate effect.

Non-domestic investors raise their demand for the domestic currency in the foreign exchange market when interest rates rise (due to a higher price level) because they seek a larger return on their savings. This increased demand, which in turn increases the real exchange rate. 

Question

The downward slope of the aggregate demand curve least likely results from?

1. The income effect.
2. The interest rate effect.
3. The real exchange rate effect.

 Solution

The correct answer is A.

The downward slope of the aggregate demand curve results from three effects: the wealth effect, the interest rate effect, and the real exchange rate effect.