the aggregate demand curve
To answer this question, we recall that the components of economy’s GDP:
Y = C + I + G + NX
We assume that government spending is fixed. The other three components: consumption, investment, and net exports depend on economic conditions and on the price level.
1. The price level and consumption: The wealth effect:
Ex: The nominal value of a dollar is fixed, yet, the real value of a dollar is not fixed.
→ A decrease in the price level raises the real value of money and makes consumers wealthier, which in turn encourages them to spend more. The increase in consumer spending means a larger quantity of goods and services demanded, vice versa.
2. The price level and investment: The interest rate effect
The price level determinant of the quantity of money demanded.
Lower price, less money demanded → money to buy interest-bearing bonds or interest-bearing saving account → drives down interest rates → borrowing less expensive → firms + households borrow more to invest → stimulate consumer spending on G&S for investing ( new hosing, equipment..)
→ A lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded, vice versa.
3. The price level and net exports: The exchange-rate effect.
A lower price level lowers the interest rate.
Ex: The interest rate on Vietnamese government bonds falls, a mutual might sell Vietnamese government bonds to buy Singaporean government bonds. This action converts VND into Singapore dollars to buy more Singaporean bonds. It increases the supply of VND in the market for foreign currency exchange.
Because each VND buys fewer units of foreign currencies, foreign goods become more expensive relative to domestic goods. It causes imports of goods to decrease because Vietnamese goods are now cheaper, Vietnamese exports increase → causes Vietnamese net exports