At each price level, the total quantity of goods and services demanded is the sum of the components of real GDP, as shown in the table. There is a negative relationship between the price level and the total quantity of goods and services demanded, all other things unchanged.
The negative slope of the aggregate demand curve suggests that it behaves in the same manner as an ordinary demand curve. But we cannot apply the reasoning we use to explain downward-sloping demand curves in individual markets to explain the downward-sloping aggregate demand curve. There are two reasons for a negative relationship between price and quantity demanded in individual markets.
First, a lower price induces people to substitute more of the good whose price has fallen for other goods, increasing the quantity demanded. Second, the lower price creates a higher real income. This normally increases quantity demanded further. Neither of these effects is relevant to a change in prices in the aggregate. When we are dealing with the average of all prices—the price level—we can no longer say that a fall in prices will induce a change in relative prices that will lead consumers to buy more of the goods and services whose prices have fallen and less of the goods and services whose prices have not fallen.
The price of corn may have fallen, but the prices of wheat, sugar, tractors, steel, and most other goods or services produced in the economy are likely to have fallen as well. Furthermore, a reduction in the price level means that it is not just the prices consumers pay that are falling.
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. The second reason for the downward slope of the aggregate demand curve is Keynes's interest-rate effect.
Recall that the quantity of money demanded is dependent upon the price level. That is, a high price level means that it takes a relatively large amount of currency to make purchases. Thus, consumers demand large quantities of currency when the price level is high. When the price level is low, consumers demand a relatively small amount of currency because it takes a relatively small amount of currency to make purchases. Thus, consumers keep larger amounts of currency in the bank.
As the amount of currency in banks increases, the supply of loans increases. As the supply of loans increases, the cost of loans--that is, the interest rate--decreases. Thus, a low price level induces consumers to save, which in turn drives down the interest rate. A low interest rate increases the demand for investment as the cost of investment falls with the interest rate.
Thus, a drop in the price level decreases the interest rate, which increases the demand for investment and thereby increases aggregate demand. The third reason for the downward slope of the aggregate demand curve is Mundell-Fleming's exchange-rate effect.
Recall that as the price level falls the interest rate also tends to fall. When the domestic interest rate is low relative to interest rates available in foreign countries, domestic investors tend to invest in foreign countries where return on investments is higher. As domestic currency flows to foreign countries, the real exchange rate decreases because the international supply of dollars increases. It is due to this law of demand that demand curve slopes downward to the right.
Now, the important question is why the demand curve slopes downward, or in other words why the law of demand describing inverse price-demand relationship is valid. We can explain this with marginal utility analysis and also with the indifference curve analysis. When the price of a commodity falls, the consumer can buy more quantity of the commodity with his given income. Or, if he chooses to buy the same amount of quantity as before, some money will be left with him because he has to spend less on the commodity due to its lower price.
This increase in real income induces the consumer to buy more of that commodity. This is called income effect of the change in price of the commodity. This is one reason why a consumer buys more of a commodity whose price falls. The other important reason why the quantity demanded of a commodity rises as its price falls, is the substitution effect.
When the price of a commodity falls, it becomes relatively cheaper than other commodities. This induces the consumer to the commodity whose price has fallen for other commodities which have now become relatively dearer. As a result of this substitution effect, the quantity demanded of the commodity, whose price has fallen, rises. This substitution effect is more important than the income effect.
Marshall explained the downward-sloping demand curve with the aid of this substitution effect alone, since he ignored the income effect of the price change. But in some cases even the income effect of the price change is very significant and cannot be ignored. We have explained above the reasons for the downward- sloping demand curve of an individual consumer.
There is an additional reason why the market demand curve for a commodity slopes downward. When the price of a commodity is relatively high, only few consumers can afford to buy it. And when the price of a commodity falls, more consumers would start buying it because some of those who previously could not afford to buy it may now afford to buy it.
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