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Appendix: Why the Aggregate Demand Curve Slopes Downward<br />

The aggregate demand curve indicates an inverse relationship between the price level and the<br />

quantity demanded of Real GDP. Economists have identified three causes of this inverse<br />

relationship:<br />

1. The wealth (real balance) effect. This is similar to the income effect discussed in Chapter 3.<br />

When the price level decreases, consumers are wealthier (their money holdings have more<br />

buying power). This means that consumers can afford to buy a greater quantity of goods and<br />

services as the price level decreases. This increase in consumption as the price level<br />

decreases will cause the aggregate demand curve to be downward sloping.<br />

2. The interest rate effect. When the price level decreases, the demand for money will<br />

decrease (as households need less money to make their normal purchases). The decrease in<br />

the demand for money will cause interest rates to decrease. As discussed earlier in this<br />

chapter, lower interest rates will cause increased consumption (particularly of durable goods)<br />

and will cause increased investment. The increases in consumption and investment as the<br />

price level decreases will cause the aggregate demand curve to be downward sloping.<br />

3. The exchange rate effect. As discussed above, when the price level decreases, interest rates<br />

will decrease. Lower interest rates in the U.S. will cause depreciation in the exchange rate for<br />

the dollar (see Chapter 16). As discussed earlier in this chapter, if the exchange rate for the<br />

dollar depreciates, net exports will increase. The increase in net exports as the price level<br />

decreases will cause the aggregate demand curve to be downward sloping.<br />

Appendix: Why the Short-Run Aggregate Supply Curve Slopes Upward<br />

The short-run aggregate supply curve indicates a direct relationship between the price level and<br />

the quantity supplied of Real GDP. Economists have identified three causes of this direct<br />

relationship.<br />

1. Sticky-wage effect. Wages in a market economy can be slow to adjust (especially<br />

downward). This stickiness is due to such factors as long-term labor contracts, labor unions,<br />

and general employee resistance to wage cuts. If the price level decreases and nominal<br />

wages do not decrease, real wage rates will be higher. The increase in real wage rates will<br />

cause employers to employ less labor and produce less output. The decrease in output due to<br />

sticky wages as the price level decreases will cause the short-run aggregate supply curve to<br />

be upward sloping.<br />

2. Sticky-price effect. Prices in a market economy can be slow to adjust (especially downward).<br />

This stickiness is due to such factors as menu costs (the costs to producers of changing the<br />

prices on their menus, catalogs, etc.) and producer concern about consumer reaction to rising<br />

prices in the future. If the price level decreases and nominal prices do not decrease, real<br />

prices will be higher. The increase in real prices will cause a decrease in sales. As sales<br />

decline, producers will produce less output. The decrease in output as the price level<br />

decreases will cause the short-run aggregate supply curve to be upward sloping.<br />

3. Misperception effect. If the price level changes, both workers and producers may<br />

misperceive the effect of the change in the price level. If the price level decreases, workers<br />

may perceive a decrease in their nominal wages as a decrease in real wages. Thus, workers<br />

may decrease the amount of labor supplied. If the price level decreases, producers may<br />

perceive a decrease in their nominal prices as a decrease in real prices and thus reduce the<br />

amount of output produced. The decrease in output as the price level decreases due to the<br />

misperceptions of workers and producers will cause the short-run aggregate supply curve to<br />

be upward sloping.<br />

FOR REVIEW ONLY - NOT FOR DISTRIBUTION<br />

6 - 9 The Aggregate Market

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