Question

) Define Aggregate Demand. 2) Give three reasons why the Aggregate Demand curve slopes downward. 3) Using the Expenditure Model (GDP = C + G + I + NX), draw a graph that depicts Demand-Pull inflation. 4) What factors cause Demand-Pull inflation? 5) Using the Expenditure Model (GDP = C + G + I + NX), what needs to be done to get back to equilibrium when an economy experiences Demand-Pull inflation?

Answer 1

Aggregate demand is the general demand for all goods and services in a complete/entire economy. It is a macroeconomic term that describes the relationship between everything bought within a country and prices. Anything that is bought in a country is the same as anything that is produced in a country. Therefore, aggregate demand equals the gross domestic product of that economy.

2.

The first reason for the downward slope of the aggregate demand curve is the Pigou wealth effect. Remember that the nominal value of money is fixed, but the real value depends on the price level. This is because for a given amount of money, a lower price level provides more purchasing power per unit of currency. When the price level falls, consumers are richer, a condition that induces higher consumer spending. Therefore, a fall in the price level induces consumers to spend more, which increases aggregate demand.

The second reason for the downward slope of the aggregate demand curve is the effect of the Keynes interest rate. Remember that the quantity of money demanded depends on the price level. That is, a high price level means that a relatively large amount of currency is required to make purchases. Therefore, consumers demand large amounts of currency when the price level is high. When the price level is low, consumers demand a relatively small amount of currency because a relatively small amount of currency is needed to make purchases. Therefore, consumers keep larger amounts of money in the bank. As the amount of currency in banks increases, the supply of loans increases. As the supply of loans increases, the cost of loans, that is, the interest rate, decreases. Therefore, a low price level induces consumers to save, which in turn lowers the interest rate. A low interest rate increases investment demand as the cost of investment falls with the interest rate. Therefore, a fall in the price level lowers the interest rate, which increases the demand for investment and thus increases the aggregate demand.

The third reason for the downward slope of the aggregate demand curve is the effect of the Mundell-Fleming exchange rate. Remember that as the price level falls, the interest rate also tends to fall. When the domestic interest rate is low relative to the interest rates available in foreign countries, domestic investors tend to invest in foreign countries where the return on investments is higher. As the national currency flows to foreign countries, the real exchange rate decreases because the international supply of dollars increases. A decrease in the real exchange rate has the effect of increasing net exports because domestic goods and services are relatively cheaper. Finally, an increase in net exports increases aggregate demand, since net exports are a component of aggregate demand. Thus, as the price level falls, interest rates fall, domestic investment in foreign countries increases, the real exchange rate depreciates, net exports increase, and aggregate demand increases.i