What determines aggregate demand?

Answer 1

1) The Wealth Effect: A higher price level reduces the purchasing power of financial wealth. Assets such as stocks, bonds, cash, and checking account balances are worth less, which shrinks the amounts you can buy. Thus, higher average prices reduce the amount of domestic production sold along an Aggregate Demand curve.

2) The Foreign-Sector Substitution Effect (real exchange rate effect): Higher prices cause domestic consumers to buy more imports and fewer domestic goods. Foreign buyers respond similarly, shrinking our exports.

Investment is affected in a similar fashion. Hikes in the price level drive up domestic production costs. A higher price level shrinks investment both foreign and domestic, firms would find it relatively more profitable to invest abroad. In sum, trends toward imports and foreign investments reinforce the wealth effect in making Aggregate Demand curves negatively sloped.

3) The Interest Rate Effect (intratemporal effect): The amount of borrowing required to finance a major purchase rises if the price level rises. A higher price level increases the demand for loanable funds and, consequently, increases the interest rate, which is the cost of credit. This increase in interest rates reduces investment and such consumer purchases as new homes, cars, or appliances. The figure below summarizes how these effects cause movements along Aggregate Demand curves as the price level changes.

Answer 2

1) The Wealth Effect: A higher price level reduces the purchasing power of financial wealth. Assets such as stocks, bonds, cash, and checking account balances are worth less, which shrinks the amounts you can buy. Thus, higher average prices reduce the amount of domestic production sold along an Aggregate Demand curve.

2) The Foreign-Sector Substitution Effect (real exchange rate effect): Higher prices cause domestic consumers to buy more imports and fewer domestic goods. Foreign buyers respond similarly, shrinking our exports.

Investment is affected in a similar fashion. Hikes in the price level drive up domestic production costs. A higher price level shrinks investment both foreign and domestic, firms would find it relatively more profitable to invest abroad. In sum, trends toward imports and foreign investments reinforce the wealth effect in making Aggregate Demand curves negatively sloped.

3) The Interest Rate Effect (intratemporal effect): The amount of borrowing required to finance a major purchase rises if the price level rises. A higher price level increases the demand for loanable funds and, consequently, increases the interest rate, which is the cost of credit. This increase in interest rates reduces investment and such consumer purchases as new homes, cars, or appliances. The figure below summarizes how these effects cause movements along Aggregate Demand curves as the price level changes.

Answer 3

The equation for aggregate demand proposed by the Mundell-Fleming model of a large open economy is Y = C(Y - T) + I(r) + G + NX(e). Y represents income or output. C(Y - T) represents consumption as a function of disposable income, defined as income less taxes.

Answer 4

1. Interest Rates

2. The Price Level

3. Real National Income