No Such Thing as a Free Lunch: Principles of Economics (Part 133)

The difference between microeconomics and macroeconomics is a bit like the difference between biology and medicine. Knowing that certain genes increase the risk of cancer is relatively easy. Figuring out exactly which people will get sick, or how to cure them, is a lot more complicated. 

- Author: Alex Berenson

Aggregate Demand, Aggregate Supply, and Inflation

(Part B)

by

Charles Lamson

Other Reasons for a Downward-Sloping Aggregate Demand Curve

In addition to the effects of money supply and money demand on the interest rate, two other factors lie behind the downward slope of the aggregate demand (AD) curve. These are the consumption link and the real wealth effect.

The Consumption Link Consumption (C) and planned investment (I) depend on the interest rate. Other things equal, consumption expenditures tend to rise when the interest rate falls and to fall when the interest rate rises just as planned investment does. This tendency is another link between the goods market and the money market. If something happens to change the interest rate in the money market, both consumption and planned investment are affected in the goods market.

The consumption link provides another reason for the AD curve's downward slope. An increase in the price level increases the demand for money, which leads to an increase in the interest rate, which leads to a decrease in consumption (as well as planned investment), which leads to a decrease in aggregate output (income). The initial decrease in consumption (brought about by the increase in the interest rate) contributes to the overall decrease in output. 

Planned investment does not bear all the burden of providing the link from a higher interest rate to a lower level of aggregate output. Decreased consumption brought about by a higher interest rate also contributes to this effect.

The Real Wealth Effect Consumption depends on wealth. Other things equal, the more wealth households have, the more they consume. Wealth includes holdings of money, shares of stock, bonds, and housing, among other things. If household wealth decreases, the result will be less consumption now and in the future.

The price level has an effect on some kinds of wealth. Suppose you are holding $1,000 in a checking account or in a money market fund and the price level rises by 10 percent. Your holding is now worth 10 percent less because the prices of the goods that you could buy with your $1,000 have all increased by 10 percent. The purchasing power (or "real value") of your holding has decreased by 10 percent.

An increase in the price level may also lower the real value of stocks and housing, although whether it does depends on what happens to stock prices and housing prices when the overall price level rises. If stock prices and housing prices rise by the same percentage as the overall price level, the real value of stocks and housing will remain unchanged. The point is:

An increase in the price level lowers the real value of some types of wealth.

The fact that the price level lowers the real value of wealth provides another reason for the downward slope of the AD curve. An increase in the price level lowers the real value of wealth. This leads to a decrease in consumption, which leads to a decrease in aggregate output (income). so, there is a negative relationship between the price level and output through the real wealth effect or real balance effect.

Aggregate Expenditure and Aggregate Demand

Throughout our discussion of macroeconomics so far, we have referred to the total planned spending by households (C), firms (I), and the government (G) as planned aggregate expenditure. AD equilibrium, planned aggregate expenditure (AE ≡ C + I + G) and aggregate output (Y) are equal:

equilibrium condition: C + I + G = Y

How does planned aggregate expenditure relate to aggregate demand? 

You can see this in Figures 1 and 2 from last post and reintroduced below. When the price level rises it is planned aggregate expenditure that decreases, moving us up the aggregate demand curve.

However, the aggregate demand curve represents more than just planned aggregate expenditure. Each point on the AD curve represents the particular level of planned aggregate expenditure that is consistent with equilibrium in the goods market and money market at the given price. Notice that the variable on the horizontal axis of the aggregate demand curve in Figure 2 is Y. At every point along the AD curve, Y = C + I + G. 

Shifts of the Aggregate Demand Curve

Consider an increase in the quantity of money supply. If the quantity of money is expanded at any given price level, the interest rate will fall, causing planned investment spending (and planned aggregate expenditure) to rise. the result is an increase in output at the given price level. As Figure 3 shows:

An increase in the quantity of money supply at a given price level shifts the aggregate demand curve to the right.

An increase in government purchases or a decrease in net taxes also increases aggregate output (income) at each possible price level, even though some of the increase will be crowded out if the money supply is held constant. (If you are unsure of what crowding-out is, review part 130.) An increase in government purchases directly increases planned aggregate expenditure, which leads to an increase in output. A decrease in net taxes results in a rise in consumption, which increases planned aggregate expenditure, which also leads to an increase in output. As Figure 4 shows:

An increase in government purchases or a decrease in net taxes shifts the aggregate demand curve to the right.

The same kind of reasoning applies to decreases in the quantity of money supplied, decreases in government purchases, and increases in net taxes. All of these shift the aggregate demand curve to the left.

FIGURE 5 Factors That Shift the Aggregate Demand Curve

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 536-538*

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