Why aggregate demand slopes down

Alternatively, it might deposit its excess cash in an interest-bearing savings account, and the bank would use these funds to make more loans. In either case, as households try to convert some of their money into interest-bearing assets, they drive down interest rates. Lower interest rates, in turn, encourage borrowing by firms that want to invest in new plants and equipment and by households who wish to invest in new housing. Thus, a lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the number of products and services demanded.

Any situation that changes net exports for a given price level also shifts aggregate demand. For example, when Europe experiences a recession, it buys fewer goods from the United States. Fewer sales reduce U. When Europe recovers from its recession, it starts repurchasing U. More people will be willing to buy American laptops which will increase the America export, and increase sales will contribute to higher GDP for America.

When currency is cheaper, it makes goods and services less expensive to the rest of the world. So it makes net exports increase. Once again, when you have a low-price level, you could have GDP expanding. Naturally, if the prices were to increase, the opposite dynamic might occur. Suppose, for instance, that international speculators bid up the value of the U. 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. Buyers become wealthier and are able to purchase more goods and services than before. A second reason is the interest rate effect. As the price level rises, households and firms require more money to handle their transactions.

However, the supply of money is fixed. The increased demand for a fixed supply of money causes the price of money, the interest rate , to rise. As the interest rate rises, spending that is sensitive to rate of interest will decline. Hence, the interest rate effect provides another reason for the inverse relationship between the price level and the demand for real GDP. The third and final reason is the net exports effect. Changes in aggregate demand.

Changes in aggregate demand are represented by shifts of the aggregate demand curve. An illustration of the two ways in which the aggregate demand curve can shift is provided in Figure. The cookie is used to store the user consent for the cookies in the category "Analytics".

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