1) The Wealth Effect: A higher price level reduces the purchasing power of financial wealth. Assets such as stocks, bonds, cash, and checking account balances are worth less, which shrinks the amounts you can buy. Thus, higher average prices reduce the amount of domestic production sold along an Aggregate Demand curve.
2) The Foreign-Sector Substitution Effect (real exchange rate effect): Higher prices cause domestic consumers to buy more imports and fewer domestic goods. Foreign buyers respond similarly, shrinking our exports.
Investment is affected in a similar fashion. Hikes in the price level drive up domestic production costs. A higher price level shrinks investment both foreign and domestic, firms would find it relatively more profitable to invest abroad. In sum, trends toward imports and foreign investments reinforce the wealth effect in making Aggregate Demand curves negatively sloped.
3) The Interest Rate Effect (intratemporal effect): The amount of borrowing required to finance a major purchase rises if the price level rises. A higher price level increases the demand for loanable funds and, consequently, increases the interest rate, which is the cost of credit. This increase in interest rates reduces investment and such consumer purchases as new homes, cars, or appliances. The figure below summarizes how these effects cause movements along Aggregate Demand curves as the price level changes.
1) The Wealth Effect: A higher price level reduces the purchasing power of financial wealth. Assets such as stocks, bonds, cash, and checking account balances are worth less, which shrinks the amounts you can buy. Thus, higher average prices reduce the amount of domestic production sold along an Aggregate Demand curve.
2) The Foreign-Sector Substitution Effect (real exchange rate effect): Higher prices cause domestic consumers to buy more imports and fewer domestic goods. Foreign buyers respond similarly, shrinking our exports.
Investment is affected in a similar fashion. Hikes in the price level drive up domestic production costs. A higher price level shrinks investment both foreign and domestic, firms would find it relatively more profitable to invest abroad. In sum, trends toward imports and foreign investments reinforce the wealth effect in making Aggregate Demand curves negatively sloped.
3) The Interest Rate Effect (intratemporal effect): The amount of borrowing required to finance a major purchase rises if the price level rises. A higher price level increases the demand for loanable funds and, consequently, increases the interest rate, which is the cost of credit. This increase in interest rates reduces investment and such consumer purchases as new homes, cars, or appliances. The figure below summarizes how these effects cause movements along Aggregate Demand curves as the price level changes.
The equation for aggregate demand proposed by the Mundell-Fleming model of a large open economy is Y = C(Y - T) + I(r) + G + NX(e). Y represents income or output. C(Y - T) represents consumption as a function of disposable income, defined as income less taxes.
1. Interest Rates
2. The Price Level
3. Real National Income
Aggregate demand
When aggregate demand and aggregate supply both decrease, the result is no change to price. As price increases, aggregate demand decreases, and aggregate supply increases.
nothing
Fiscal policy is centered on aggregate demand.
No effect. Spending will decrease Aggregate Demand, lower taxes will raise Aggregate Demand
Aggregate demand
nothing
When aggregate demand and aggregate supply both decrease, the result is no change to price. As price increases, aggregate demand decreases, and aggregate supply increases.
Fiscal policy is centered on aggregate demand.
No effect. Spending will decrease Aggregate Demand, lower taxes will raise Aggregate Demand
The interest rate does affect aggregate demand. As the interest rate falls, aggregate demand increases and vice-versa.
Aggregate demand curve.
AD-AS represents aggregate demand curve (AD) and aggregate supply curve (AS). "In the aggregate demand-aggregate supply model, each point on the aggregate demand curve is an outcome of the IS-LM model for aggregate demand Y based on a particular price level. Starting from one point on the aggregate demand curve, at a particular price level and a quantity of aggregate demand implied by the IS-LM model for that price level, if one considers a higher potential price level, in the IS-LM model the real money supply M/P will be lower and hence the LM curve will be shifted higher, leading to lower aggregate demand; hence at the higher price level the level of aggregate demand is lower, so the aggregate demand curve is negatively sloped
The aggregate demand curve shifts to the right
The quantity of full employment in the aggregate supply aggregate demand model is similar to the conditions in which other model. (Market Supply and Demand.)
An increase in aggregate demand and a decrease in aggregate supply will result in a shortage: there will be more goods and services demanded than that which is being produced.
An increase in aggregate demand and a decrease in aggregate supply will result in a shortage: there will be more goods and services demanded than that which is being produced.