Question

Suppose that investment spending is always \(\$ 250,\) government purchases are \(\$ 100\), net exports are always \(\$ 50\), and consumer spending depends on the price level in the following way: On a piece of graph paper, use these data to construct an aggregate demand curve. Why do you think this example supposes that consumption declines as the price level rises?

Short answer

Answer: To construct the aggregate demand curve, we need to sum up consumption (C), investment (I), government spending (G), and net exports (NX). First, we write the aggregate demand equation: AD = C + I + G + NX. Then, we plug in the given values and establish a consumption function that shows consumption decreases as the price level increases. Finally, we insert the consumption function into the aggregate demand equation, simplify, and plot the aggregate demand curve on a graph with a negative slope, given the relationship between consumption and the price level.

Step-by-step solution

Write the Aggregate Demand Equation

First, we need to write the aggregate demand equation, which is the sum of consumption (C), investment (I), government spending (G), and net exports (NX). The equation is as follows: AD = C + I + G + NX

Plug in the Given Values

Now, we can plug in the values given in the exercise (investment spending, government purchases, and net exports) along with the relationship they provided for consumer spending: AD = C(Price level) + \(250 + \)100 + $50

Add the Consumption Function

We don't have an explicit consumption function given in the exercise, but it describes that consumption decreases as the price level increases. To visualize this, we can think of the consumption function as having a negative slope: C = A - B * (Price level) where A is a constant representing the maximum consumption and B is a positive constant that reflects the rate at which consumption decreases with an increase in the price level.

Insert the Consumption Function into the Aggregate Demand Equation

Now, we can insert this consumption function into the aggregate demand equation: AD = (A - B * (Price level)) + \(250 + \)100 + $50

Simplify the Equation

Now, let us simplify the aggregate demand equation: AD = A - B * (Price level) + $400

Plot the Aggregate Demand Curve

To plot the aggregate demand curve, use graph paper and select two arbitrary points on the price level axis. In this exercise, we assume that consumption declines as the price level rises, so the aggregate demand curve will have a negative slope. Using the consumption function and the values for investment, government purchases, and net exports, one can calculate AD for the two price levels chosen. Now, plot the aggregate demand curve, taking the calculated aggregate demand values on the Y-axis and the corresponding price levels on the X-axis. Draw a curve connecting these points, which represents the aggregate demand curve. In conclusion, this exercise demonstrates the construction of an aggregate demand curve using the given information about investment spending, government purchases, net exports, and the relationship between consumption and the price level. The assumption that consumption declines as the price level rises is likely based on the idea that higher price levels make consumption less affordable, leading to a decrease in overall demand.

Key concepts

Macroeconomics

Macroeconomics is a branch of economics that studies how the overall economy—the market systems that operate on a large scale—behaves. It encompasses a variety of factors including total national income, the distribution of income, employment, and inflation. Aggregate demand is a key concept within macroeconomics and represents the total demand for goods and services within a certain economy at a given overall price level and in a given time period.

Aggregate demand is influenced by several components, notably consumption (C), investment (I), government purchases (G), and net exports (NX). Changes in these components can lead to shifts in the aggregate demand curve. For example, if consumer confidence is high, consumption can increase, shifting the aggregate demand curve to the right. On the flip side, if taxes increase and consumers have less disposable income, consumption may decrease, shifting the curve to the left.

Investment Spending

Investment spending refers to the total amount of money spent on capital goods, such as factories, machinery, and equipment, that will be used to produce other goods and services in the future. This component of aggregate demand is crucial because it directly affects productivity and economic growth.

Investments are not only limited to physical capital but can also include investments in human capital such as education and training. Factors that influence investment spending include interest rates, expected returns, and economic conditions. For instance, lower interest rates tend to encourage more investment spending as it becomes cheaper to borrow money.

Government Purchases

Government purchases are expenditures on goods and services by local, state, and federal governments. It's a part of the aggregate demand in an economy. This can range from infrastructure projects like roads and bridges to services like public education and defense.

Unlike other components of aggregate demand, government spending is somewhat independent of the price level in a given period as it is often predetermined by budgets and fiscal policies. It can have a significant impact on the economy's demand as it directly adds to the overall spending, potentially increasing employment and resource utilization within a country.

Net Exports

Net exports refer to the value of a country's exports minus its imports. When a country exports more than it imports, it has a trade surplus, and when it imports more than it exports, it has a trade deficit. Net exports can affect the aggregate demand curve because changes in global demand for products, exchange rates, and international economic conditions can all lead to fluctuations in a country's exports and imports.

An increase in net exports would shift the aggregate demand curve to the right, indicating an increase in overall demand. Conversely, a decrease would shift the curve to the left. Additionally, government policies such as tariffs and trade agreements can substantially influence net exports and therefore the position of the aggregate demand curve.