Aggregate Demand

The diagram on the left shows aggregate demand.

As you can see, it slopes downwards.

But WHY does it slope downwards?

The aggregate demand schedule shows that, ceteris paribus, as prices increase, the quantity of goods and services demanded in the aggregate falls. This is not questioned in the microeconomic case, where a higher price for a good causes both a substitution and an income effect away from the good. However, in the macro sense, there may be neither an income nor a substitution effect.

Students often glance over an aggregate demand curve and use their logic to conclude if prices are generally higher, there is an income effect which means that consumers cannot afford to buy as many goods. However, we know that this concept is fundamentally flawed. First, there is the case of a perfect (a.k.a. pure) inflation, where all prices and all incomes rise by the same percent. We know that this would cause no real effects. All consumers buying power would remain the same and all producers would maintain the same profit margin, all lenders would receive the same real interest rate, and all borrowers would still be paying the same real interest rate.

With other than perfect inflations, we know that changes in relative prices can redistribute income. If wages rise less than prices, then workers lose buying power, but producers gain profits which increases the income of shareholders. If real interest rates fall because nominal rates rise less than the increase in inflation, new borrowers gain since they pay less in interest. New lenders lose since they receive less in real terms for the use of their money. In the case of existing loans, with a fixed nominal rate, borrowers gain since they pay interest and principle with dollars which are worth less. The gain of borrowers is offset by the loss of lenders.

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