What’s it: An aggregate demand curve is a graph showing the inverse relationship between aggregate demand and the price level. Aggregate demand represents the total demand from four macroeconomic sectors: household, business, government, and external sectors. In a graph, the aggregate demand curve is downward sloping (negative slope).
Why does the aggregate demand curve slope downward
The concept of aggregate demand curve slope is slightly different from the demand curve in microeconomics. In microeconomics, you discuss individuals. Meanwhile, in macroeconomics, you discuss the economy as a whole.
Prices in microeconomics represent the price of a product. Meanwhile, economists use the term price level in macroeconomics to represent all products’ prices.
We call an increase in the price level as inflation. And in this case, the indicator to measure it is the GDP deflator.
You cannot use inflation figures from the price index when discussing aggregate demand. The price index includes only a few products. For example, the consumer price index only represents goods and services consumed by households, excluding goods for production. Likewise, the producer price index only represents goods purchased by producers, excluding consumer products.
Next, to explain why the aggregate demand curve slopes downward, you must first break down the components. Then, you explain the relationship of each component to the price level.
Okay, I’ll try to decipher it.
Aggregate demand consists of demand from four main sectors, namely:
- Household consumption
- Business investment
- Government spending
- Net exports
Overall, the price level is inversely related to aggregate demand components, except for government spending.
The effect of the price level on household consumption
The price level affects household wealth. Household’s real wealth increases when the price level falls. It increases their purchasing power.
The increase in purchasing power encourages households to increase their consumption. So, we can conclude, a decrease in the price level will increase household consumption.
The reverse effect also applies. A higher price level reduces household consumption. Household real incomes fall, and their purchasing power weakens.
We call this effect of changes in the price level on household consumption through real wealth as the wealth effect.
The effect of the price level on business investment
A lower price level reduces the demand for money. To buy goods in the same quantity as before, economic actors need less money.
In financial markets, a decrease in the demand for money will push the price of money down. And, in economics, the price of money is the interest rate. Thus, a lower price level will lower the interest rate.
Lower interest rates reduce the cost of investing in capital, encouraging businesses to increase their investment.
Not only that. Low-interest rates also encourage households to apply for new loans. For some items such as houses and cars, households do not buy in cash but are financed through loans. Therefore, when interest rates are low, households will also tend to spend more on those goods.
The opposite effect also applies when the price level rises. That drives interest rates up and weakens business investment and household consumption.
You can also use the Fisher equation to understand the relationship between the price level (inflation) and the interest rate. Fisher defined:
Nominal interest rate = Inflation rate + Real interest rate
The nominal interest rate represents the cost you have to pay when borrowing money.
From this equation, we know that the nominal interest rate will also increase when the inflation rate rises. And when that goes down, the nominal interest rate goes down too.
The effect of the price level on government spending
No correlation is between the price level and government spending. Government spending is a discretionary policy and is determined more by the political process. Therefore, we classify government spending as an autonomous expenditure. Its value does not depend on economic conditions.
The effect of the price level on net exports
Net exports are the difference between export value and import value. A fall in the price level indicates that domestic goods are becoming cheaper. It attracts foreign buyers and encourages them to increase demand. As a result, exports increase.
On the other hand, a reduction in rates makes foreign-produced goods and services less attractive to domestic buyers. As a result, imports decrease.
So, in general, when the price level falls, net exports will increase. Conversely, when the price level increases, net exports will decrease.
What shifts the aggregate demand curve
Changes in the price level cause aggregate demand to move along the curve. Meanwhile, changes in other factors shift the curve.
Several factors increase aggregate demand and, accordingly, shift the curve to the right. They include:
- Expansionary fiscal policy. The government stimulates aggregate demand by increasing its spending or lowering taxes. An increase in spending has a direct effect on an increase in aggregate demand. Conversely, lower tax rates have an indirect impact on aggregate demand, namely through an increase in household disposable income and an increase in business profits.
- Expansionary monetary policy. The central bank stimulates aggregate demand by increasing the money supply. The options are to cut policy interest rates, reduce the reserve requirement ratio, and open market operations through government securities purchases. These all drive interest rates in the economy down, increasing household consumption and business investment.
- Increase in household wealth. An increase in wealth encourages households to spend more money on goods and services.
- Consumers are more optimistic. Consumers feel more confident about their income and job security in the future. It encourages them to spend a higher proportion of income on the consumption of goods and services.
- Business is more optimistic. If companies see better future returns, they are likely to invest more in capital projects.
- Exchange rate depreciation. Depreciation makes domestic goods cheaper for foreign buyers and encourages them to increase demand. As a result, exports increase. On the other hand, depreciation makes imported goods more expensive. Domestic buyers reduce their demand (imports fall). Thus, on the whole, depreciation raises net exports and aggregate demand.
- Strong global economic growth. It drives up the demand for domestic goods and encourages exports. Assuming imports are constant, more robust global growth increases net exports.