Negative Slope of the Aggregate Demand Curve

Reasons Explaining the Negative Slope of the Aggregate Demand Curve

First, we must remember that aggregate demand, GDP, or the output of an economy is divided into consumption, investment, government spending, and net exports, that is:

Each of these four components contributes to the aggregate demand for goods and services. Since we assume that government spending (G) is determined by policy, the other three components depend on the price level. Consequently, in order to understand why the aggregate demand curve has a negative slope, we must explain how the price level affects the quantity of goods and services demanded for consumption, investment, and net exports.

The Price Level and Consumption: Wealth Effect

The nominal value of money is fixed, but the real value can change as a consequence of an increase or decrease in the price level. When the price level decreases, the real value of money increases because consumers with the same amount of money can purchase more goods and services. This makes consumers relatively wealthier and encourages them to spend more. Consequently, an increase in consumption spending raises the quantity of goods and services demanded.

The opposite is also true. An increase in the price level in the economy results in a decrease in the real value of money. As a result, consumers now have the ability to acquire a smaller quantity of goods and services, making them poorer in real terms and causing a decline in the quantity of goods and services demanded for consumption.

This effect of the change in the price level on the real wealth of consumers and their ability to demand goods and services is known as the wealth effect.

The Price Level and Investment: Interest Rate Effect

The price level is a determinant of the amount of money demanded in the economy. When the price level is low, the amount of money that people need for their daily transactions decreases, and consequently, the demand for money falls. When people demand less money, they seek alternatives for the money they already possess, leading to an increase in the demand for interest-bearing assets. Consequently, when the population seeks to convert some of their money holdings into interest-bearing assets, interest rates decrease as a result of the increase in the supply of money available for loans and investment. Interest rates, in turn, affect spending on goods and services, as lower interest rates reduce the cost of borrowing money, especially for investment. In summary, a lower price level reduces interest rates, which stimulates spending on investment goods and thus increases the quantity of goods and services demanded.

The opposite is also true. When the price level increases, people require a greater amount of cash to carry out their daily transactions, so they seek to increase their money holdings. Consequently, the amount of money available to invest in interest-bearing assets and loans decreases. By reducing the supply of money available for loans and investment, interest rates rise. With higher interest rates, borrowing becomes more expensive, and less money is lent for investment goods, which leads to a reduction in the demand for goods and services.

This process that occurs when a change in the price level affects the amount of cash available for loans and investment, and thus affects the interest rate and the amount of loans allocated to the demand for investment goods and services, is known as the interest rate effect.

The Price Level and Net Exports: Exchange Rate Effect

As we saw earlier, when the price level decreases, the interest rate also decreases. Consequently, the value of the currency falls in the foreign exchange market. The depreciation of the currency stimulates net exports and increases the quantity of goods and services demanded for export.

Conversely, an increase in the price level leads to an increase in the interest rate, the real value of the currency rises, and this appreciation reduces net exports and the quantity of goods and services demanded from abroad.

The decline in the value of the currency as a result of the decrease in the interest rate occurs because, with low interest rates, investors want to take some of their money abroad in search of better investment returns. This leads to currency exchange, where the supply of the national currency increases in the foreign exchange market, resulting in a decrease in its value.

The reason net exports increase with a devalued currency is that importing becomes relatively more expensive. Conversely, purchasing domestic goods from abroad is now relatively cheaper.

All this process of the effect that a change in the price level has on the interest rate, subsequently on the value of the currency, and finally on net exports is known as the exchange rate effect.

Relationship Between the Money Market and the Slope of the Aggregate Demand Curve

To illustrate the relationship between the money market and the slope of the aggregate demand curve, in the first graph we have the aggregate demand curve and in the second graph the money market. Let’s assume a reduction in the price level (P); in the graph, we move from P1 to P2. The reduction in the price level causes a decrease in the demand for money. As a consequence, in the money market, the money demand curve shifts to the left, resulting in a reduction of the interest rate from R1 to R2. Consequently, the decrease in the interest rate in the money market generates an increase in the quantity demanded of goods and services, moving from Y1 to Y2.

A lower interest rate reduces the cost of borrowing, and in turn, it also reduces the return on savings. As a consequence, investment by companies and consumption by households increase. Thus, when the price level decreases, the demand for money falls, subsequently lowering the interest rate, and consequently, the aggregate demand for goods and services increases.

The opposite is also true: an increase in the price level results in an increase in the demand for money and a shift of the money demand curve to the right. This occurs because now, at each interest rate, people want and need to hold a greater amount of money, given that a higher price level requires a larger amount for each transaction made. The shift of the money demand curve generates an increase in the interest rate and subsequently a decrease in aggregate demand.

Note that the result is a negative relationship between the price level and the quantity demanded of goods and services, which is the cause of the negative slope of the aggregate demand curve.

The Negative Slope of the Demand Curve Explained with the Quantity Theory of Money