Aggregate Demand Curves

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Aggregate Demand Curve: A negative relationship between the general price level (P) and the quantity demanded (Q) of total national output. ______________________________________________________________________ Aggregate Demand for national output is underpinned by the purchases of four groups of ultimate buyers: (a) consumers, (b) investors, (c) government, and (d) foreigners. Their spending plans are interdependent, and are combined in an Aggregate Demand curve. The amount of national output each group buys depends, in part, on the price level. An Aggregate Demand curve depicts a negative relationship between the price level and purchases of national output.
If the price level rises, purchases of our national output fall, and vice versa. Foundations for the negative slopes of Aggregate Demand curves are variations on the substitution and income effects used to justify negative slopes of individual demand curves. The Aggregate Demand curve is negatively sloped because of (a) the wealth effect, (b) the foreign-sector substitution effect, and (c) the interest rate effect. The negatively sloped Aggregate Demand curve above is based on these effects. • The Wealth Effect Will your money buy as much if prices soar? Of course not. A higher price level reduces the purchasing power of financial wealth. Assets such as stocks, bonds, cash, and checking account balances are worth less, which shrinks the amounts you can buy. Thus, higher average prices reduce the amount of domestic production sold along an Aggregate Demand curve. • The Foreign-Sector Substitution Effect  Might buyers tend to switch from Buicks to Saabs if prices of American cars rose relative to those for imports? Of course. Higher U.S. prices cause domestic consumers to buy more imports and fewer American goods. Foreign buyers respond similarly, shrinking U.S. exports. Investment is affected in a similar fashion. Hikes in the price level drive up domestic production costs. If you headed a firm considering a new manufacturing facility, you would be more likely to build it in Mexico if U.S. prices and costs rose. Thus, a higher price level shrinks investment in this country because both foreign and U.S. firms would find it relatively more profitable to invest abroad. In sum, trends toward imports and foreign investments reinforce the wealth effect in making Aggregate Demand curves negatively sloped. • The Interest Rate Effect The amount of borrowing required to finance a major purchase rises if the price level rises. For example, you might need to borrow more to finance your education if tuition costs were to rise. Thus, a higher price level increases the demand for loanable funds and, consequently, increases the interest rate, which is the cost of credit. This increase in interest rates reduces investment and such consumer purchases as new homes, cars, or appliances. The figure below summarizes how these effects cause movements along Aggregate Demand curves as the price level changes.

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Author: Ralph Byrns

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