Question

a. The demand curve for a single product is downsloping because of the

• income and substitution effects but these effects don't apply to the aggregate demand curve.

• income and substitution effects and these effects also apply to the aggregate demand curve.

• wealth and real interest rate effects but these effects don't apply to the aggregate demand curve.

• wealth and real interest rate effects and these effects also apply to the aggregate demand curve.

b. With the aggregate demand curve, moving down the curve means

• all prices are dropping, the price level is dropping, and with regard to the circular flow of economic activity, it also indicates lower incomes. With the single product demand curve the consumer's income is assumed to be fixed.

• all prices are dropping, the price level is dropping, and with regard to the circular flow of economic activity, it also indicates lower incomes. With the single product demand curve the consumer's income also drops with movement down the curve.

• all prices are rising, the price level is rising, and with regard to the circular flow of economic activity, it also indicates higher incomes. With the single product demand curve the consumer's income is assumed to be fixed.

• all prices are rising, the price level is rising, and with regard to the circular flow of economic activity, it also indicates higher incomes. With the single product demand curve the consumer's income also rises with movement down the curve.

Answer 1

a. The main two reasons for the downward slope of the demand curve of a particular product are income effect and substitution effect.

The income effect states that with fall in price the consumer’s real income increases. It means that with fall in price, the consumer is able to purchase more units of the commodity with a given amount of income. This is just like an increase in income of the consumer.

The substitution effect says that when the price of one commodity fall it become relatively cheaper than the other. Thus the consumer spends more of his income on the commodity whose price falls and less on the commodity whose price does not fall.

But in case of aggregate demand, as it is the demand for a variety of goods these income and substitution effect cannot be applied. The price level applies to the aggregated demand is general price level but not individual price level. So it is difficult and impossible to assume that the aggregate demand increase with income effect and price effect when the price falls. Thus the income effect and substitution effect cannot apply to the aggregate demand. The aggregate demand is downward sloping due to wealth effect, interest rate effect and net export effect.

Answer: income and substitution affects but these effects don’t apply to the aggregate demand curve.

b. The fall in price level leads to low productivity. As per circular flow, the factors are less demanded during time of dropping prices. This will reduce the income of the people. Regarding the aggregated demand the fall in income reduce it. But the demand curve for an individual product is made on the assumption that the consumer’s income remaining constant.

Answer: all prices are dropping, the price level in dropping, and with regard to the circular flow of economic activity, it also indicates lower incomes, with the single product demand curve the consumer’s income is assumed to be fixed.