Slope of the Aggregate Demand Curve

Lesson 12

E>R>E phrases (to be written out from the English text) for translation by ear.

CHAPTER 16: MICROFOUNDATIONS OF MACROECONOMIC POLICY

The macroeconomic goals of high employ­ment, a stable price level, and healthy eco­nomic growth are intertwined, but historical data seem to reveal few systematic connections between these variables. The U.S. economy has experienced growth when average prices were rising—and when average prices were falling. Similarly, inflationary episodes have been ac­companied by low unemployment rates—and by widespread unemployment. Unraveling this jumble of dataentails examining relative shifts in Aggregate Demand and Aggregate Supply.

THE AGGREGATE DEMAND CURVE

Now that you know why the relative shifts of Aggregate Demand and Aggregate Supply mat­ter, let's reexamine the foundations for these curves.

The Aggregate Demand curve reflects a nega­tive relationship between the price level (P) and the quantity demanded (Q) of National Output.

We will take a moment to review why Aggregate Expenditures on our domestic productiontend to be sensitive to the price level and why Aggregate Demand curves are negatively sloped.

Slope of the Aggregate Demand Curve

All else being equal, planned spending on U.S. production falls when the domestic price level rises because of

1. The interest rate effect, whereby higher in­terest rates reduce planned investment, Aggregate Expenditures, and, ultimately, output.

2. The wealth effect, whereby the purchasing power of assets stated in money terms falls, causing declines in wealth, and, conse­quently, in spending.

3. The foreign sector substitution effect, whereby consumers substitute goods produced else­where forAmerican-made goods, while in­vestors find that the profitability of foreign investment has risen relative to that for in­vestment in the United States.

When the price level rises, each mechanism operates to reduce the Aggregate Expenditures schedule, which results in a leftward movement along the Aggregate Demand curve. For simplicity, we will tem­porarily assume that all domestic prices, in­cluding wages and rents, increase by exactly the same proportion.

• Interest Rate Effects A major reason for the negative slope of the Aggregate Demand curve is the effect that higher prices have on the chain reaction from interest rates to investment to Aggregate Spending and then to income and output.

When prices rise, the real purchasing power of a fixed money supply (M/P) falls. Higher interest rates that re­sult from higher prices crowd out investment and, in addition, squeeze both consumer credit and government spending at the state and local levels (especially that which is bond financed). In summary, higher interest rates reduce all these sources of Aggregate Spending.

• The Wealth Effect Suppose the price level were to fall sharply. To the extent that your wealth would rise because of the increased pur­chasing power of your assets held as money, you could buy more goods and would spend more. Conversely, even if your monetary income kept up with the price level during inflation, you would still lose to the extent that your wealth was stored as bonds, as cash, or in bank accounts, so you would reduce your spending.

A related adjustment occurs because most of us want to maintain fairly stable amounts of liquid assets relative to our income. Thus, even if your income rises as fast as the price level, you may temporarily reduce the proportion of in­come you consume to restore the purchasing power of your liquid assets through a short-term higher rate of saving. Because consumption de­clines as the price level climbs (due to the wealth effect), Aggregate Spending also falls in a man­ner similar to that described for the interest rate-investment adjustments in Figure 1.

• Foreign Sector Substitution Effect We im­port goods when foreigners can produce them at lower cost and export goods when American production costs are lower than those in other countries. If the prices of U.S. goods rise, you will buy more imported goods than previously because they will be relatively cheaper. At the same time, foreign consumers will reduce their purchases of now higher-priced American goods. Thus, inflation causes imports to increase and exports to decrease, resulting in reduced Aggregate Expenditures and National Income and Output.

Increases in American prices are usually ac­companied by higher U.S. costs of production. Higher wages and increased costs for U.S. land and machinery make it profitable for investors (both foreign and domestic) to substitute foreign investment for investment in the United States, reinforcing the decline in Aggregate Expendi­tures as the price level rises. Over the last three decades many U.S. manufacturers have expanded operations in Mexico, Taiwan, and other low-wage countries.

To summarize, higher price levels are as­sociated with lower quantities along Aggregate Demand curves because (a) higher interest rates reduce investment and purchases of consumer durables, (b) real values fall for financial assets stated in monetary terms, (c) imports grow and exports fall, and (d) domestic investment de­clines while foreign investment flourishes.

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