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The Effects of Aggregate Demand

Aggregate expenditures and price are inversely related. A rise in price level will cause a decrease in aggregate expenditures and a decrease in price level will cause an increase in aggregate expenditures. There are three things that explain why falling price levels increase aggregate expenditures.
They are:

  • The Wealth Effect: This says that a rise in the price level will make people who have money and other financial assets feel poorer. They then buy less, and the opposite is true if the price level were to fall- people would buy more. If people feel poorer and since consumption is a part of AD, then aggregate expenditures will decrease, thus decreasing the quantity demanded.
  • The International Effect: This states that as the price of our goods go up -and become more expensive to foreigners- net exports will fall. In addition, imports will increase because foreign goods will seem cheaper than the goods at home whose prices have risen. Since net exports will fall and this is a part of AD, then overall aggregate expenditures will decrease.
  • The Interest Rate Effect: This says that as price increases, interest rates will increase causing investments to decrease. If prices are higher, then people will have less money because they will be forced to spend more. If interest rates are higher, people will be less willing to put what little money they have into investments. Since Investments are part of the aggregate demand, the quantity of aggregate expenditures will go down, showing a negative relationship between price and aggregate expenditures.

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