Question

can you explain why the aggregate demand curve is downward sloping using the money market ?

Answer 1

Ans: The Aggregate Demand curve represents the total quantity of all goods and services demanded by the economy at different price levels. The Aggregate Demand Curve is downward sloping because of the following reasons:

1. Wealth Effect : The AD curve is based on the assumption that government holds the nominal money supply(M) constant. As the price level rises the wealth of the economy measured by the supply of money declines in value because the purchasing power falls and when the price level falls the wealth increases in the value and thus purchasing power rises. Thus wealth effect explains the one reason for the inverse realtionship between the Real GDP and Price level.
2. Interest Rate Effect: As the Price level increases, the Real Money Supply (M/P) declines; Thus as P rises; households require more money to carry out their transactions. But the Nominal supply of money is constant. Thus the increased demand for money in comparison with the fixed supply causes the price of money; the interest rate to rise As the interest rate rises the Investment declines and so does AD and real GDP

Money Market is the interaction between the institutions and parties through which money is supplied to firms, individuals etc who are the demanders of money. Money Market Equilibrium occurs where the deamnd for money is equal to the supply of money. The Demand for money is downward sloping curve which shows the quantity of money demanded as function of interest rate all other things held constant. Money demand curve is downward sloping.

Money supply curve is assumed to the vertical assuming that the money supply does not depend on the interest rate. Thus the equlibriumin the money market occurs where downward sloping money demandcurve and vertical real money supply curve intersects.

Thus in the 1st part of graph below the money market equilibrium is shown as the intersection of downward sloping money demandcurve and vertical real money supply curve. As the P rises the Real money supply declines and the curve shifts leftwards which causesthe interest rate to rise from i to i₁ and thus beacuse Investment is negatively related to interest rate investment declines and so does the aggregate spending level declines; thus there is negative relationship between AD and P because due to increase in P; AD has reduced