Notes on AD and SRAS

Notes on AD and SRAS - Understanding AD and SRAS Why Does...

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Understanding AD and SRAS Why Does the Aggregate Demand Curve Slope Downward? Remember that all explanations for the negative slope of AD must start with a change in price and end with a change in Y in the opposite direction – after all, you are explaining the movement from one point to another along the same AD curve. The Wealth Effect Suppose P falls, but nominal money holdings (basically referring to your current holdings of liquid money and denoted by M) stays the same. Real money holdings (denoted as (M/P) rise when general price levels fall, so consumption increases. Thus Y increases and you move to a new point on the AD curve. The Interest Rate Effect When price levels fall, if households do not increase their consumption at the same rate, they will save more. But in the loanable funds market, if savings increase then the interest rate falls and firm are then able to borrow more. There is then increased investment by firms in plants, machinery and equipment. Thus Y increases and you move to a new point on the AD curve. The exchange rate effect Note that this explanation occurs as a result of the falling savings in “the interest rate effect” explanation above. So when real interest rates fall, then there is increased capital outflow which drives up the demand for foreign currency (or reduces the supply of foreign currency). This causes a depreciation of the domestic currency and an increase in net exports.
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