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Chapter 24: Problem 7

An economics student makes the following statement: "It's easy to understand why the aggregate demand curve is downward sloping: When the price level increases, consumers substitute into buying less expensive products, which decreases total spending in the economy." Briefly explain whether you agree.

Short Answer

Expert verified
While the statement by the student partly reflects one possible reaction to rising prices, the primary reasons why the aggregate demand curve is downward sloping are the wealth effects and the interest rate effects, not the substitution of less expensive goods.

Step by step solution

01

Understanding the concept

The aggregate demand curve reflects the quantity of all goods demanded by an economy at different price levels. It is downward sloping due to two primary reasons: wealth effects and interest rate effects. The statement by the student only focusses on the effect of substitution of less expensive goods, which actually plays a minimal role in creating downward slope of aggregate demand curve.
02

Wealth effects

The primary reason that the aggregate demand curve is downward-sloping is due to the wealth effects. When prices decrease while the money supply remains unchanged, the real value of money – purchasing power – increases. Therefore, consumers are wealthier in real terms, which leads to an increase in consumer spending. Conversely, when prices increase, the real value of money declines, leading to less consumer spending.
03

Interest rate effects

The second reason is the interest rate effects. When the price level decreases, the demand for money also decreases. In response, interest rates will decline, leading to more investment spending. The lower interest rates will decrease the cost of borrowing, thereby encouraging businesses to invest in capital and households to spend more on big-ticket items like houses and cars. The opposite happens when the price level increases.
04

Case of substitution

While substitution from more expensive goods to less expensive goods may happen at an individual level, it does not significantly contribute to the overall shape of the aggregate demand curve in an economy. Microeconomic substitution effects are minor compared to the macroeconomic wealth and interest rate effects.

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Most popular questions from this chapter

Briefly explain how each of the following events would affect the long-run aggregate supply curve. a. A higher price level b. An increase in the labor force c. An increase in the quantity of capital goods d. Technological change

In \(2017,\) an article in the Wall Street Journal discussing the latest data on U.S. net exports noted that, along with other currencies, "the [Chinese] yuan has risen this year against the dollar." The article also noted that there had been "stronger [economic] growth in Asia and Europe." a. What does the article mean by noting that the yuan had "risen" against the dollar? b. Briefly explain whether the combination of other currencies rising against the dollar and stronger economic growth in Asia and Europe had led to an increase or a decrease in U.S. net exports. c. Will the outcome you discuss in part (b) result in a movement along the U.S. aggregate demand curve or a shift of the curve? Briefly explain.

A student is asked to draw an aggregate demand and aggregate supply graph to illustrate the effect of an increase in aggregate supply. The student draws the following graph: The student explains the graph as follows: An increase in aggregate supply causes a shift from \(\operatorname{SRAS}_{1}\) to \(S R A S_{2}\). Because this shift in the aggregate supply curve results in a lower price level, consumption, investment, and net exports will increase. This change causes the aggregate demand curve to shift to the right, from \(\mathrm{AD}_{1}\) to \(\mathrm{AD}_{2}\). We know that real GDP will increase, but we can't be sure whether the price level will rise or fall because that depends on whether the aggregate supply curve or the aggregate demand curve has shifted farther to the right. I assume that aggregate supply shifts out farther than aggregate demand, so I show the final price level, \(P_{3}\), as being lower than the initial price level, \(P_{1}\). Explain whether you agree with the student's analysis. Be careful to explain exactly what - if anything-you find wrong with this analysis.

What are menu costs? If menu costs were eliminated. would the short-run aggregate supply curve be a vertical line? Briefly explain.

Explain why the long-run aggregate supply curve is vertical.
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