In the first few chapters of this book, we introduced the notion of supply and demand. One of the first things that we did was to derive the relationship between the price of a product and the quantity demanded per time period by an individual household. Now we have derived what we call the aggregate demand curve. The two look the same and both have a negative slope, but the ogiv is completely different. Tell one story that explains the negative slope of a simple demand curve and another story that explains the more complex AD curve.
What will be an ideal response?
Answer: The demand curve of a commodity slopes downward from left to right. The reason is that more of a commodity is demanded at lower price and only less at a higher price. At a lower price more is demanded because people who do not consume a commodity will start buying it when it price falls. At the same time the existing buyers will buy more as the commodity can be put now for less urgent uses also.
Why the existing consumers buy more at low price. This tenancy is applicable to the Law of Diminishing marginal Utility.
According to this law, the marginal utility of a commodity decreases as the stock of it increases. So no rational consumer will, therefore pay for a commodity more than its marginal utility obtained. It means that an individual will buy more units of a commodity only when its price falls. Thus a consumer will buy more units when the price falls as the utility falls unless does not.
The existing consumers buy more at a low price because of the positive Income Effect. If the price of a commodity falls, it is just like an increase in income of the consumers. When the price falls, the consumer is able to buy the same quantity with lesser amount than before. The extra income thus saves from the price falls is used to buy more units of the commodity.
At a lower price the people who do not buy the commodity will start to buy the commodity due to the Substitution Effect. A fall in price makes a commodity comparatively cheaper to other commodities. Thus the people who already buying a costlier commodity start to buy the cheaper commodity. In other words the people will substitute the cheaper commodity for the costlier ones. Therefore the demand for the commodity increases when its price falls.
Aggregate demand is the total quantity of all goods and services demanded in an economy. It is the sum of consumption demand, investment demand, government purchase and net export (C+I+G+Nx). The aggregate demand curve shows the total quantity of goods and services demanded by the economy at different price level. Like the demand curve for a commodity, the aggregate demand curve also slopes downward from left to right showing the inverse relation between price and the total quantity demanded. The reasons for the downward slope of aggregate demand are wealth effect, Interest rate effect and net export effect.
1. Wealth effect.
Money is a kind of wealth. When the price level increases the value of money as a wealth decreases. As the value of money decrease people demand less. On the other hand when the price level falls the value of money as an asset increase. Thus the people demand more as the value of their wealth increase.
2. Interest rate effect.
Money is demanded mostly for transaction purposes. A rise in price level makes the available money insufficient to meet the transaction demand. Then the people will start to borrow money. This increased demand for borrowing rise the rate of interest. The increased rate of interest reduces the level of investment. Thus aggregate demand decrease with the rise in price level. On the other hand a fall in price level via lower interest rate increases the investment and aggregate demand.
3. Net export effect.
When the price level increase the domestic goods become costly in the foreign exchange market. This will reduce net export and thereby reduce the aggregate demand. On the other, when the price level falls domestic goods become cheaper in foreign market and export increase and thereby the aggregate demand.
In short the more is the aggregate demand at a lower price and less at a higher price and the aggregate demand curve also sloped downward like the demand curve of a an individual product.
You might also like to view...
Refer to the figure below. In response to gradually falling inflation, this economy will eventually move from its short-run equilibrium to its long-run equilibrium. Graphically, this would be seen as 
A. long-run aggregate supply shifting leftward B. Short-run aggregate supply shifting upward C. Short-run aggregate supply shifting downward D. Aggregate demand shifting leftward
Leverage refers to
A) the ratio of total assets of a financial institution to total liabilities. B) the ratio of the liabilities of a financial institution to equity capital.. C) the ratio of equity capital of a financial institution to the liabilities. D) the ratio of the debt of a financial institution to liabilities.
All else equal, it is more likely for a case to be settled the ________ the defendant's assessment of the expected payment to the plaintiff and the ________ the plaintiff's assessment of the expected (received) payment.
A) smaller; smaller B) smaller; larger C) larger; larger D) larger; smaller
The MRP = MFC maximization rule applies to capital just as it does to labor
Indicate whether the statement is true or false