The aggregate demand curve graphically represents the inverse relation between the price level and aggregate expenditures. A higher price level is related to fewer aggregate expenditures and a lower price level is related to greater aggregate expenditures. That is, the household, business, government, and foreign sectors are inclined to increase their spending on real production if the price level declines and decrease spending if the price level rises.
The key question is: Why? Why does the aggregate demand curve have a negative slope? The three reasons underlying the negative slope of the AD curve and the inverse relation between the price level and aggregate expenditures on real production are: real-balance effect, interest-rate effect, and net-export effect.
Before examining the details of these three effects, consider the specifics of how the price level and aggregate expenditures are related. A typical aggregate demand curve is presented in the exhibit to the right. The negative slope of the aggregate demand curve captures the inverse relation between the price level and aggregate expenditures on real production.
|Along the Curve|
When the price level changes, one or more of these three effects are activated, which is what then results in a change in aggregate expenditures and the movement along the aggregate demand curve. To illustrate this process, click the [Change Price Level] button.
Real-Balance EffectAt any given time, the economy has a limited quantity of money in circulation. Money is what the four sectors use to purchase production. How much production they can purchase depends on the amount of money in circulation relative to the prices of the goods and services produced, that is the price level. As the price level changes, the purchasing power of the money supply also changes. A higher price level means money cannot buy as much production. A lower price level means money can buy more production.
This triggers the real-balance effect. Definitionally speaking, the real-balance effect occurs when a change in the price level changes aggregate expenditures on real production because the purchasing power of money changes. In other words, members of the household, business, government, and foreign sectors are simply able to buy a different amount of production.
Suppose, for example, that Duncan Thurly's share of the nation's money supply is $10. At a price of $2 each, he can afford to purchase five Wacky Willy Stuffed Amigos (those cute and cuddly armadillos and scorpions). However, if the price level rises, and with it the price of Stuffed Amigos, then he can no longer afford to purchase five cuddly creatures. At $2.50 each, he can now afford to buy only four Stuffed Amigos. His share of aggregate expenditures on REAL production has declined from five Stuffed Amigos to four. The purchasing power of his $10 of money has fallen and with it his aggregate expenditures on real production. He has succumbed to the real-balance effect.
Interest-Rate EffectMost investment expenditures by the business sector and a fair amount of consumption expenditures by the household sector (especially for durable goods) are made with borrowed funds. Businesses typically borrow the funds needed for capital goods like factories and equipment. Households often borrow the funds used to buy durable goods like cars and furniture. The cost of borrowing these funds depends on the interest rate. A higher or lower interest rate can add to or subtract from the overall cost of the expenditure.
This means that changes in the interest rate can have a big impact on consumption and investment expenditures. The interest rate tends to increase and decrease as the price level increases and decreases. This means that a higher price level induces a higher interest rate which raises the cost of borrowing and discourages investment and consumption spending. A lower price level has the opposite result.
A change in investment and/or consumption expenditures triggered by a change in the interest rate that is triggered by a change in the price level is the interest-rate effect.
Suppose, for example, that Duncan Thurly is primed and ready to buy a brand new OmniMotors XL GT 9000 Sports Coupe. Because this purchase will set him back over $20,000, which exceeds his available bank account balance, he plans to borrow the necessary funds. A four-year loan with a 10 percent interest rate, results in monthly payments of $507, an expense he can handle. However, a boost in the price level that increases the interest rate on this loan to 12 percent results in monthly payments of $527. This extra $20 causes Duncan to pause and rethink this planned purchase. If he decides the extra expense is too much, then he has fallen victim to the interest-rate effect.
Net-Export EffectAggregate demand is the demand for domestic production--goods and services produced by the domestic economy. A change in the price level is a change in the price of this domestic production. Other countries in the foreign sector produce goods and services, too. If the price level changes in domestic economy, then the relative prices of production in other countries also change.
If the domestic price level increases, then buyers in other countries (the foreign sector) are discouraged from buying as many domestic exports, switching instead to their own production or maybe exports from yet another country. In addition, domestic buyers (including the household, business, and government sectors) are motivated to switch from the more expensive domestic production to the now relatively cheaper foreign imports.
This comparison of prices among different countries gives rise to the net-export effect. In particular, an increase in the price level increases imports and decreases exports, which results in a decrease in net exports. A decrease in the price level has the opposite result.
Suppose, for example, that Duncan Thurly has a daily craving for cheese that is satisfied by purchasing good ol' American-made cheese produced in the American state of Wisconsin. This daily purchase is, of course, an expenditure on domestic production. How might Duncan react if the domestic economy's price level, and with it the price of Wisconsin cheese, increases? He might satisfy his cheese-craving with the imported variety, probably Swiss cheese from Switzerland. If so, then his expenditures on domestic production (Wisconsin cheese) falls as his purchase of foreign production (Swiss cheese) increases. The end result is that Duncan has become a living, breathing, cheese-eating application of the net-export effect.
SLOPE, AGGREGATE DEMAND CURVE, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2019. [Accessed: November 12, 2019].