Answer to Question #146381 in Macroeconomics for Sania riaz

Question

Most economist are of the view that AD curve is downward sloping. Provide theoretical justification for this view.
What are the reasons for shifts in AD?

Answer 1

$$Solution$$

There are three main explanations for the downward sloping aggregate demand curve. These are the wealth effect of Pigou, the interest-rate effect of Keynes, and the exchange-rate effect of Mundell-Fleming. These three explanations for the downward sloping aggregate demand curve are different, but function together.

a) Pigou's wealth effect-The nominal value of money is fixed, but the actual value depends on the price level. This is because a lower price level offers more buying power per unit of currency for a given amount of money. If the price level falls, consumers are wealthier, a situation that contributes to more consumer spending. As a result, a decrease in the price level encourages buyers to spend more thus rising aggregate demand.

b) Keynes' interest-rate effect-The quantity of money needed depends on the price level. That is, a high price level means that a reasonably large sum of money is required to make purchases. Consumers thus demand a significant amount of currency when the price level is high. If the price level is low, buyers are asking for a relatively small amount of money because a relatively small amount of money is required to make purchases. Thus a low price level encourages customers to save money, which in turn reduces the interest rate. Low interest rates boost investment demand as investment costs decline at interest rates. As a result, a decrease in the price level lowers the interest rate, which increases investment demand and as a result, increases aggregate demand.

c) Mundell-Fleming Exchange rate effect-The price level is also decreasing, and the interest rate continues to decline. When the domestic interest rate is low compared to the interest rates available in foreign countries, domestic investors prefer to invest in foreign countries where the return on investment is higher. When domestic currency flows to foreign nations, the actual exchange rate declines as the international supply of dollars rises. Decreasing the real exchange rate has the effect of rising net exports, as domestic products and services are comparatively cheaper. Finally, the rise in net exports raises aggregate demand, as net exports are part of aggregate demand. As prices fall, interest rates fall, domestic investment in foreign countries rises, real exchange rates depreciate, net exports grow, and aggregate demand rises.