Why does the aggregate demand curve slope downwards

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Table of Contents Show

1. The Wealth Effect
2. The Interest Rate Effect
3. The Exchange Rate Effect
IS-LM model of aggregate demand

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To understand why the aggregate demand curve is downward sloping, we have to look at the relationship between the price level and the components of GDP (see also how to calculate GDP). More specifically, we have to analyze how the price level affects the quantity of goods and services demanded for consumption, investments, and net exports. By doing so, we can identify three distinct but related reasons why the aggregate demand curve is downward sloping: (1) the Wealth Effect, (2) the Interest Rate Effect, and (3) the Exchange Rate Effect. We will look at each of them in more detail below.

1. The Wealth Effect

A decrease in the price level makes consumers wealthier, which increases consumer spending. The reason for this is that the real value of money depends on its buying power and not on its nominal value (i.e., the face value). That means when prices fall, consumers can afford to buy more goods and services with the same amount of money. This increase in wealth encourages them to spend more, which in turn increases the aggregate quantity of goods and services demanded.

To give an example, let’s look at an imaginary country called Smolland. Smolland has 100 inhabitants. Each of them has USD 10.00 in their pockets. For the sake of this example, we’ll assume that there is only one product sold in Smolland: ice cream. One ice cream cone costs USD 2.00 (P1 in the illustration above). That means each inhabitant can buy 5 cones, and aggregate demand adds up to 500 cones (Y1). However, if the price of ice cream falls to USD 1.00 (P2), each inhabitant can buy 10 cones with the same USD 10.00 they had before. Thus, they become more wealthy, and the aggregate quantity demanded increases to 1,000 cones (Y2).

2. The Interest Rate Effect

A decrease in the price level lowers the interest rate, which increases investment spending by businesses as well as consumer spending. The reason for this is that the quantity of money demanded is dependent on the price level. That means when the price level falls, consumers need less currency to buy the goods and services they want so they can keep a larger share of their money in the bank. The bank then uses these funds to make more loans, which drives the interest rate (i.e., the price of the loan) down, and vice versa (see also the law of supply and demand). A lower interest rate reduces the cost of investments, which increases investment spending by businesses. In addition to that, it may also encourage consumer spending on interest rate sensitive goods, such as cars or housing, which are typically purchased with the help of loans or mortgages, respectively.

To illustrate this, let’s revisit Smolland. This time, however, we’ll assume that people don’t have to spend all their money on consumption. Instead, they can deposit a share of their funds in savings accounts. At the original price of USD 2.00 per cone, the consumers buy 500 cones, which adds up to USD 1000. Thus, in the initial scenario, they don’t deposit any money in the bank. However, if the price falls to USD 1.00, people can buy the same amount of ice cream for half the price (i.e., 500 cones x USD 1.00 = USD 500) and deposit the other half of their money in the bank (i.e., USD 500). The bank can then use that money to make a loan to the ice cream seller, which allows the latter to invest in additional equipment and increase their production capabilities.

3. The Exchange Rate Effect

A decrease in the domestic price level lowers the value of the local currency, which increases net exports. The reason for this is that the low domestic price level causes the local interest rate to fall (see above). Whenever that happens, domestic investors tend to shift their investments to foreign countries with higher interest rates to get a better return. This shift causes the real exchange rate (i.e., the relative price of domestic and foreign goods and services) to depreciate because the international supply of the local currency increases.

When the real exchange rate falls, domestic consumers will find that imports become relatively more expensive. So they buy less from abroad, and imports decrease. Meanwhile, domestic exports become relatively cheaper for foreigners to buy, so exports increase. As a result, net exports (i.e., exports – imports) rise, which increases the quantity of goods and services demanded.

In the case of Smolland, we can illustrate this by introducing a second country. Let’s say people can get the same ice cream from another imaginary country in Europe. We’ll call it Coneland. Now, assume the price level (and thereby the interest rate) in Smolland decreases. This causes investors from Smolland to shift some of their investments to Coneland. However, to do that, they have to exchange some of their USD to EUR. This increases the international supply of USD, which causes the currency to depreciate. As a result, it becomes relatively cheaper for people from Coneland to buy ice cream from Smolland and relatively more expensive for people from Smolland to buy ice cream from Coneland. Hence, the real exchange rate decreases and net exports rise.

Summary

To understand why the aggregate demand curve is downward sloping, we have to analyze how the price level affects the quantity of goods and services demanded for consumption, investments, and net exports. By doing so, we can identify three distinct but related reasons why the aggregate demand curve is downward sloping: The Wealth Effect, the Interest Rate Effect, and the Exchange Rate Effect. The Wealth Effect states that a decrease in the price level makes consumers wealthier, which increases consumer spending. The Interest Rate Effect states that a decrease in the price level lowers the interest rate, which increases investment spending by businesses as well as consumer spending. Finally, the Exchange Rate Effect states that a decrease in the domestic price level lowers the value of the local currency, which increases net exports.

Figure %: Graph of the aggregate demand curve.

The most noticeable feature of the aggregate demand curve is that it is downward sloping, as seen in . There are a number of reasons for this relationship. Recall that a downward sloping aggregate demand curve means that as the price level drops, the quantity of output demanded increases. Similarly, as the price level drops, the national income increases. There are three basic reasons for the downward sloping aggregate demand curve. These are Pigou's wealth effect, Keynes's interest-rate effect, and Mundell-Fleming's exchange-rate effect. These three reasons for the downward sloping aggregate demand curve are distinct, yet they work together.

The first reason for the downward slope of the aggregate demand curve is Pigou's wealth effect. Recall that the nominal value of money is fixed, but the real value is dependent upon the price level. This is because for a given amount of money, a lower price level provides more purchasing power per unit of currency. When the price level falls, consumers are wealthier, a condition which induces more consumer spending. Thus, a drop in the price level induces consumers to spend more, thereby increasing the aggregate demand.

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. A decrease in the real exchange rate has the effect of increasing net exports because domestic goods and services are relatively cheaper. Finally, an increase in net exports increases aggregate demand, as net exports is a component of aggregate demand. Thus, as the price level drops, interest rates fall, domestic investment in foreign countries increases, the real exchange rate depreciates, net exports increases, and aggregate demand increases.

IS-LM model of aggregate demand

There is another major model that is useful for explaining the nature of the aggregate demand curve. This model is called the IS-LM model after the two curves that are involved in the model. The IS curve describes equilibrium in the market for goods and services where Y = C(Y - T) + I(r) + G and the LM curve describes equilibrium in the money market where M/P = L(r,Y). The IS-LM model exists in a plane with r, the interest rate, on the vertical axis and Y, being both income and output, on the horizontal axis. The IS-LM model has the same horizontal axis as the aggregate demand curve, but a different vertical axis.

Figure %: Graph of the IS-LM curves.

The IS curve describes equilibrium in the market for goods and services in terms of r and Y. The IS curve is downward sloping because as the interest rate falls, investment increases, thus increasing output. The LM curve describes equilibrium in the market for money. The LM curve is upward sloping because higher income results in higher demand for money, thus resulting in higher interest rates. The intersection of the IS curve with the LM curve shows the equilibrium interest rate and price level.