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The Slope of the Aggregate Demand Curve

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Students learn in microeconomics that the demand curve for a good, which shows the relationship between the price of a good and the quantity of the good that consumers demand- i.e. are willing, ready, and able to purchase- has a negative slope. This negative slope reflects the observation that people demand more of almost all goods when they gets cheaper and vice versa.

In contrast, the aggregate demand curve used in macroeconomics shows the relationship between the overall (i.e. average) price level in an economy, usually represented by the GDP Deflator, and the total amount of all goods produced in an economy. (Note that "goods" in this context technically refers to both goods and services.) Specifically, the aggregate demand curve shows real GDP, which represents both total output and total income in an economy, on its horizontal axis. As it turns out, the aggregate demand curve also slopes downwards, giving a similar negative relationship between price and quantity that exists with the demand curve for a single good. The reason that the aggregate demand curve has a negative slope, however, is quite different.

In a lot of cases, people consume less of a particular good when its price increases because they have an incentive to substitute away to other goods that have become relatively less expensive as a result of the price increase. On an aggregate level, however, this is somewhat difficult to do- though not totally impossible, since consumers can substitute away to imported goods in some situations. Therefore, the aggregate demand curve must slope downwards for different reasons. In fact, there are three reasons why the aggregate demand curve exhibits this pattern: the wealth effect, the interest-rate effect, and the exchange-rate effect.

The Wealth Effect

When the overall price level in an economy decreases, consumers' purchasing power increases, since every dollar they have goes further than it used to. On a practical level, this increase in purchasing power is similar to an increase in wealth, so it shouldn't be surprising that an increase in purchasing power makes consumers want to consume more. Since consumption is a component of GDP (and therefore a component of aggregate demand), this increase in purchasing power caused by a reduction in the price level leads to an increase in aggregate demand.

Conversely, an increase in the overall price level decreases the purchasing power of consumers, making them feel less wealthy, and therefore decreases the amount of goods that consumers want to purchase, leading to a decrease in aggregate demand.

The Interest-Rate Effect

While it is true that lower prices encourage consumers to increase their consumption, it is often the case that case that this increase in the amount of goods purchased still leaves consumers with more money left over than they had before. This left over money is then saved and lent out to companies and households for investment purposes.

The market for "loanable funds" responds to the forces of supply and demand just like any other market, and the "price" of loanable funds is the real interest rate. Therefore, the increase in consumer saving results in an increase in the supply of loanable funds, which decreases the real interest rate and increases the level of investment in the economy. Since investment is a category of GDP (and therefore a component of aggregate demand), a decrease in the price level leads to an increase in aggregate demand.

Conversely, an increase in the overall price level tends to decrease the amount that consumers save, which lowers the supply of savings, raises the real interest rate, and lowers the quantity of investment. This decrease in investment leads to a decrease in aggregate demand.

The Exchange-Rate Effect

Since net exports (i.e. the difference between exports and imports in an economy) is a component of GDP (and therefore aggregate demand), it's important to think about the effect that a change in the overall price level has on the levels of imports and exports. In order to examine the effect of price changes on imports and exports, however, we need to understand the impact of an absolute change in the price level on relative prices between different countries.

When the overall price level in an economy decreases, the interest rate in that economy tends to decline, as explained above. This decline in the interest rate makes saving via domestic assets look less attractive compared to saving via assets in other countries, so demand for foreign assets increases. In order to purchase these foreign assets, people need to exchange their dollars (if the U.S. is the home country, of course) for foreign currency. Like most other assets, the price of currency (i.e. the exchange rate) is determined by the forces of supply and demand, and an increase in demand for foreign currency increases the price of foreign currency. This makes domestic currency relatively cheaper (i.e. the domestic currency depreciates), meaning that the decrease in the price level not only reduces prices in an absolute sense but also reduces prices relative to the exchange-rate adjusted price levels of other countries.

This decrease in the relative price level makes domestic goods cheaper than they were before for foreign consumers. The currency depreciation also makes imports more expensive for domestic consumers than they were before. Not surprisingly, then, a decrease in the domestic price level increases the number of exports and decreases the number of imports, resulting in an increase in net exports. Because net exports is a category of GDP (and therefore a component of aggregate demand), a decrease in the price level leads to an increase in aggregate demand.

Conversely, an increase in the overall price level will increase interest rates, causing foreign investors to demand more domestic assets and, by extension, increase the demand for dollars. This increase in demand for dollars makes dollars more expensive (and foreign currency less expensive), which discourages exports and encourages imports. This decreases net exports and, as a result, decreases aggregate demand.

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