The Relationship Between Aggregate Demand And The Price Level

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  • Created by: Cara Li
  • Created on: 26-03-15 12:34

The Relationship Between Aggregate Demand And The

- Aggregate demand is inversely reated to the price level. A rise in the price level causes a fall in AD. And a fall in the price level results in a rise in AD.

There are 3 effects which explain why the AD curve is downward sloping when there is a rise in the price level:

  - The wealth effect. A rise in the price level reduces the purchasing power of wealth ans so causes AD to contract.

  - The rate of interest. A rise in the price level means that some people will sell financial assets, such as government bonds, to obtain more money to pay the higher prices. 

  - The international trade effect. A rise in the price level will make the country's products less competitive. This would cause households and firms to buy more from foreign producers and less from domestic producers. Net exports would fall and AD would contract.

So the AD curve slopes down from left to right, since a rise in the price level would reduce montary wealth, raise the interest rate and reduce the country's internatinal competitiveness.

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