Question

Explain whether you agree with the following statement: "The reason the aggregate demand curve slopes downward is that when the price level is higher, people cannot afford to buy as many goods and services."

Short answer

The statement is partially correct as it includes only the wealth effect, one of the three reasons for the downward slope of the aggregate demand curve. In addition to this, the interest-rate effect and international-trade effect are also significant reasons.

Step-by-step solution

Defining Aggregate Demand

Aggregate Demand (AD) refers to the total demand for all goods and services within an economy at a certain price level and in a certain time period. In economic graphs, it is generally represented as a downward-sloping curve.

Explaining the Downward Slope of Aggregate Demand

Three main reasons cause the AD curve to slope downward: the wealth effect, the interest-rate effect, and the international-trade effect. The wealth effect proposes that when the general price level decreases, people’s purchasing power increases, leading to the consumption of more goods and services. The interest-rate effect suggests that as price levels decrease, so does the demand for money, resulting in lower interest rates and increased investment and consumption. The international-trade effect states that as the domestic price level decreases relative to the foreign price level, exports increase and imports decrease, leading to more demand for domestically produced goods.

Assessment of The Given Statement

While 'people's inability to buy goods at a higher price level’ echoes the wealth effect, it is not the sole reason the AD curve slopes downward. Therefore, the initial statement is partly correct but incomplete as it does not take into account the interest-rate effect and international-trade effect.

Key concepts

Wealth Effect

Imagine you have a fixed amount of money to spend. When prices go down, the purchasing power of your money goes up. This means you can buy more with the same amount of money, or simply put, you feel richer. This phenomenon is known as the wealth effect.

In the context of the aggregate demand curve, as the price level in an economy decreases, consumers perceive an increase in their real wealth because their income can buy more goods and services than before. This perception often leads to an increase in consumer spending, which in turn drives the demand for goods and services. Consequently, the aggregate demand curve slopes downward; as price levels drop, the quantity of goods and services demanded swells.

Interest-Rate Effect

Now let's dive into the interest-rate effect, which links the price level to investment spending, affected by changes in the interest rate. When prices fall, consumers need less money to make purchases, which means there's more money available in the banking system.

This surplus of funds tends to lower interest rates as banks have more capital to lend. Lower interest rates encourage businesses and individuals to borrow and invest in various projects or consumption. This boost in investment and consumer spending leads to an increase in the overall demand for goods and services. Hence, when the price level diminishes, not only does consumer spending rise due to the wealth effect, but investment spending also tends to rise due to falling interest rates, further contributing to the downward slope of the aggregate demand curve.

International-Trade Effect

Crossing borders, the international-trade effect comes into play when we consider how changes in price levels affect a country's international competitiveness. If a country's price level drops, its goods and services become cheaper compared to foreign markets. As a result, the country's exports become more attractive on the global market, while imports, conversely, start to look expensive.

This shift favors domestic production and consumption - local goods are now relatively cheaper than foreign ones. Thus, an increase in exports and a decrease in imports bolster the aggregate demand, especially demand for domestically produced goods and services. So, the lower the price level, the more competitive a country's products are globally, which in turn, pushes the aggregate demand curve downward.