Question

QUESTIONS

The aggregate demand curve portrays the relationship between price level and real GDP. What are the three reasons this relationship is a negative or inverse relationship? Provide brief illustrations of each.

Chapter 14&15 Aggregate Demand and Aggregate Supply

Answer 1

The wealth effect, therefore, provides one reason for the inverse relationship between the price level and real GDP that is reflected in the downward‐sloping demand curve.

A second reason is the interest rate effect. As the price level rises, households and firms require more money to handle their transactions. However, the supply of money is fixed. The increased demand for a fixed supply of money causes the price of money, the interest rate, to rise. As the interest rate rises, spending that is sensitive to rate of interest will decline. Hence, the interest rate effect provides another reason for the inverse relationship between the price level and the demand for real GDP.

The third and final reason is the net exports effect. As the domestic price level rises, foreign‐made goods become relatively cheaper so that the demand for imports increases. However, the rise in the domestic price level also means that domestic‐made goods are relatively more expensive to foreign buyers so that the demand for exports decreases. When exports decrease and imports increase, net exports (exports ‐ imports) decrease. Because net exports are a component of real GDP, the demand for real GDP declines as net exports decline.