Chapter 29 - Aggregate Demand and Aggregate Supply
Aggregate Demand and Aggregate Supply
1. Why is the aggregate demand curve downsloping? Specify how your explanation differs from
the explanation for the downsloping demand curve for a single product. What role does the
multiplier play in shifts of the aggregate demand curve?
The aggregate demand (AD) curve shows that as the price level drops,
purchases of real domestic output increase.
The AD curve slopes downward for three
The first is the interest-rate effect.
We assume the supply of money to be fixed.
When the price level increases, more money is needed to make purchases and pay for
With the money supply fixed, the increased demand for it will drive up its price,
the rate of interest.
These higher rates will decrease the buying of goods with borrowed
money, thus decreasing the amount of real output demanded.
The second reason is the real balances effect.
As the price level rises, the real value—the
purchasing power—of money and other accumulated financial assets (bonds, for
instance) will decrease.
People will therefore become poorer in real terms and decrease
the quantity demanded of real output.
The third reason is the foreign purchases effect.
As the United States’ price level rises
relative to other countries, Americans will buy more abroad in preference to their own
At the same time foreigners, finding American goods and services relatively
more expensive, will decrease their buying of American exports.
Thus, with increased
imports and decreased exports, American net exports decrease and so, therefore, does the
quantity demanded of American real output.
These reasons for the downsloping AD curve have nothing to do with the reasons for the
downsloping single-product demand curve.
In the case of the dropping price of a single
product, the consumer with a constant money income substitutes more of the now
relatively cheaper product for those whose prices have not changed.
Also, the consumer
has become richer in real terms, because of the lower price of the one product, and can
buy more of it and all other products.
But with the AD curve, moving down the curve
means all prices are dropping—the price level is dropping.
Therefore, the single-product
substitution effect does not apply.
Also, whereas when dealing with the demand for a
single product the consumer’s income is assumed to be fixed, the AD curve specifically
excludes this assumption.
Movement down the AD curve indicates lower prices but, with
regard to the circular flow of economic activity, it also indicates lower incomes.
are dropping, so must the receipts or revenues or incomes of the sellers.
Thus, a decline
in the price level does not necessarily imply an increase in the nominal income of the
economy as a whole.