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Why the Aggregate Demand Curve Slopes Downward

If the price of Pepsi rises, the quantity of Pepsi demanded decreases because some people can't afford to buy as much soda (an income effect) and because some people switch to drinking Coke and other sodas (a substitution effect). The demand curve for Pepsi slopes downward because of an income effect and a substitution effect.

The aggregate demand curve slopes downward for analogous reasons. Real GDP has three main substitutes: money, future real GDP, and foreign real GDP These substitutes give rise to three influences of the price level on the quantity of real GDP demanded:

  • Real money balances effect
  • Intertemporal substitution effect
  • International substitution effect

  • Real Money Balances Effect

    Money is currency and bank deposits-the things you use to buy goods and services and pay bills. Real money is the purcbasingpower of money or the quantity of goods and services that money will buy. It is measured by the quantity of money divided by the price level.

    The real money balances effect is the change in the quantity of real GDP demanded that results from a change in the quantity of real money. The greater the quantity of real money (that is, the greater the purchasing power of money), the greater is the quantity of real GDP demanded. But the quantity of real money increases if the price level falls, so a fall in the price level brings an increase in the quantity of real GDP demanded and a movement along the aggregate demand curve.

    To see how the real money balances effect works, think about your own spending plans. You have $5 to spend, and coffee costs $2.50 a cup. Your money can buy 2 cups of coffee. But if coffee cost $1 a cup, your $5 could buy 5 cups. The lower the price, the more you can buy with a given quantity of money so the greater is your purchasing power. And the greater your purchasing power, the more goods you plan to buy.

    The real money balances effect is analogous to the income effect on the demand for individual goods and services. But income is a flow and money is a stock, which is part of wealth, so the two effects are not identical. The other two reasons for the downward-sloping aggregate demand curve are substitution effects.


    Intertemporal Substitution Effect

    The intertemporal substitution effect is the change in the quantity of real GDP demanded resulting from a change in the opportunity cost of goods and services today in terms of goods and services in the future. The main influence on this opportunity cost is the interest rate. The higher the interest rate, the greater is the opportunity cost of buying today. By not buying today, but by saving instead, you can earn interest. The higher the interest rate, the greater is the amount you earn on your savings and the more you can buy in the future. So the higher the interest rate, the greater is the opportunity cost of buying today.

    The interest rate is influenced by the price level. The higher the price level, other things remaining the same, the higher is the interest rate. The reason is connected to the real money balances effect that you've just learned about. With a higher price level, people have less purchasing power, so the amount they want to lend decreases and the amount they want to borrow increases (other things remaining the same). A decrease in the supply of loans and an increase in the demand for loans means that interest rates rise.

    So as the price level rises, other things remaining the same, the interest rate also rises and the quantity of real GDP demanded decreases.


    International Substitution Effect

    The international substitution effect is the change in the quantity of real GDP demanded resulting from a change in the opportunity cost of domestic goods (and services) in terms of foreign goods. An example is your decision to buy a Toyota car that was made in japan instead of a GM car made in the United States. Another example is your decision to take a ski trip to the Canadian Rockies instead of to Colorado.

    The higher the price level in the United States, other things remaining the same, the higher are the prices of U.S.-made goods and services relative to foreign-made goods and services and the fewer U.S.made goods and services people buy. So the higher the price level, the smaller is the quantity of real GDP demanded.

    For the three reasons just reviewed, the aggregate demand curve slopes downward. The higher the price level in the United States, the smaller is the quantity demanded of U.S.-made goods and services-U.S. real GDP. The lower the price level in the United States, the larger is the quantity demanded of U.S.made goods and services-U.S. real GDR

    F27.6 Changes in the Quantity of Real GDP Demanded

    The quantity of real GDP demanded

    because of the:

    Real money balances effect:

  • An increase in the price level decreases the quantity of real money
  • A decrease in the price level increases the quantity of real money
  • Intertemporal substitution effect:

  • An increase in the price level increases interest rates
  • A decrease in the price level decreases interest rates
  • International substitution effect

  • An increase in the price level increases the cost of domestic goods and services relative to foreign goods and services
  • A decrease in the price level decreases the cost of domestic goods and services relative to foreign goods and services