Why the aggregate demand curve slopes downwards

Overview

Aggregate demand curve.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Describe the aggregate demand curve, naming both axes and stating its slope.

   Model answer

   The general price level is measured on the vertical axis and real national output, that is real GDP, on the horizontal axis. The aggregate demand curve slopes downwards from left to right, showing that a lower general price level is associated with a larger quantity of real output demanded. Each point on the curve gives total planned spending by households, firms, government and overseas buyers at that price level.

2. 2

   Analyse the real balance effect as a reason why aggregate demand slopes downwards.

   Model answer

   Households and firms hold money and other assets with values fixed in money terms. A fall in the general price level raises the real purchasing power of those holdings, so the same balances now command more goods and services and people feel wealthier. They respond by consuming more, so total planned spending on real output rises. A rise in the price level does the reverse, eroding real balances and cutting consumption, which is why higher price levels are associated with lower real output demanded.

3. 3

   Analyse the interest rate effect as a reason why the aggregate demand curve slopes downwards.

   Model answer

   A higher general price level means a larger sum of money is needed to finance a given volume of transactions, so the demand for money rises. With the supply of money given, the price of borrowing is bid up and interest rates rise. Dearer credit discourages investment projects and interest-sensitive consumer spending on housing and durable goods, so planned real spending falls. Real output demanded is therefore lower at a higher price level.

4. 4

   Analyse the international trade effect as a reason why the aggregate demand curve slopes downwards.

   Model answer

   If the domestic general price level rises while prices abroad and the exchange rate are unchanged, domestically produced goods become dearer relative to foreign ones. Foreign buyers switch away from exports and domestic buyers switch towards imports, so exports fall and imports rise and net exports deteriorate. Since net exports are a component of aggregate demand, planned spending on domestic output falls, giving the downward slope.

5. 5

   Set out the three reasons for the downward slope of the aggregate demand curve in a single answer, naming the axes.

   Model answer

   On a diagram with the general price level on the vertical axis and real national output on the horizontal axis, three effects explain the negative slope. The real balance effect: a higher price level erodes the purchasing power of money holdings, so consumption falls. The interest rate effect: a higher price level raises the demand for money and hence interest rates, so investment and credit-financed consumption fall. The international trade effect: a higher domestic price level worsens price competitiveness, so exports fall and imports rise and net exports deteriorate. All three reduce planned real spending as the price level rises.

6. 6

   Why is it wrong to explain the downward slope of aggregate demand by saying that cheaper goods lead consumers to substitute towards them?

   Model answer

   Substitution requires an alternative to switch to, but the horizontal axis of an aggregate demand diagram measures all domestic output taken together, so there is no other domestic good available. When the general price level falls, all domestic prices fall together, so relative prices within the economy are unchanged. The genuine reasons operate through real money balances, interest rates and competitiveness against foreign output, not through substitution between domestic goods.

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