Question

Why is the aggregate demand curve downsloping? Specify how your explanation differs from the explanation for the downsloping demand curve for a single product. What role does the multiplier play in shifts of the aggregate demand curve?

Short answer

The domestic product purchase and price level are inversely related; thus, the aggregate demand (AD) curve slopes downward.

The demand curve shows the micro-framework for a single product, but the AD curve shows the macro framework.

The multiplier effect leads to shifting the AD curve more than the change in AD.

Step-by-step solution

Aggregate demand curve

The aggregate demand curve slopes downward for three reasons first, rate of interest effect; second, real balance effect; third, foreign purchase effect.

• When the money supply is fixed as the price level increases, the money demand increases to satisfy the purchase. The supply of money is fixed as the demand increases; the price will go up, i.e., the interest rate. Thus, with a higher rate of interest, the real output demanded reduces.

• With the increase in the price level, the purchasing power of money and other financial assets falls. Hence, the consumers will become poorer, and the demand for real output will fall.

• The price level in the U.S. rises relative to other countries. The goods from other countries will be cheaper for the U.S. consumer; thus, imports will increase. The other countries will find U.S. products expensive; therefore, the export falls. The U.S. net export will fall, and the real output of the U.S. will fall.

Downsloping demand curve for a single product

The single product demand curve does not sync with the aggregate demand curve asthe aggregate demand curve represents the economy's price level as a whole. In contrast, the single product demand curve shows the price of that particular product.

The reason for the aggregate demand curve sloping downward is not valid for a single product demand curve. The single product demand curve slopes downward as the price of any product increases; the consumer reduces the demand of the product as the real income falls. Here, the price change does not say that the nominal income increases as a whole.

The multiplier effect

The multiplier effect intensifies the shift of the AD curve due to changes in the component of the AD curve. Suppose government spending increases by $2 billion as part of the AD curve; the MPC is 0.5; the simple multiplier will be 2. Initially, government spending increased by $2 million, but after successive round multiplier effect, it by $4 million (=2 *2). Thus, after the shift required real output at each price level will be $4 million.