Lesson 20 ª

Aggregate demand Function

The aggregate demand curve represents the quantity of goods and services that the inhabitants, companies and public entities want to buy at every price level.

The aggregate demand curve has a negative slope: if prices increase people will want to buy less and if prices decrease they will want to buy more.

When we studied the IS and LM curves before (don't look at me with tht face; I repeat, the IS-LM curves..., no I'm not talking about a tecno-pop group) we saw that they moved in the short term, with fixed prices.

However, now, upon studying aggregate demand, we are going to consider that it moves with a greater time frame when the prices vary:

In fact, the demand curve shows the relationship between income levels and price levels so that the different analysed markets (goods, services and money market) are in equilibrium.

Let's see how the aggregate demand curve is determined:

We have seen that in the short term (with fixed prices) the crossing point of the IS-LM curves supposes a balanced situation in the goods, services and money market.

In the money market we have considered that the real monetary offer (monetary offer/price) is fixed, assuming a level of prices Po.

If we represent in a diagrame the level of balanced income "Yo" (determined by the cross IS-LM) and the level of prices "Po" we will have a first point in the aggregate demand curve (A).

Let's try and determine a second point in the aggregate demand curve (come on!):

Let's suppose that the prices increase from Po to P1. Therefore, the real monetary offer reduces (the denominator is greater), and the curve will move towards the left. The new balance point in the money market (given the determined income level) implies a higher interest rate.

This involves the LM curve moving towards the left, the new cross point with the IS curve will determine a lower income level "Y1".

Therefore, "P1" has a lower level of income "Y1". Now we have a second point in the aggregate demand curve (B).

We are going to try and determine a third point in the aggregate demand curve (is everyone with me?):

Let's suppose now that prices go down to P2 (P2 < Po). The real monetary offer increases (the denominator is less), the curve moves towards the right. The new balance point in the money market will determine a lower interest rate.

The LM curve will move towards the right, and the new cross point with the IS curve will establish a new balance point with a higher income level "Y2".

Therefore, "P2" will have a greater income level "Y2". We already have a third point in the aggregate demand curve (C).

We have seen the negative relationship between the level of income and the level of prices, which is what explains why the aggregate demand curve is negative.

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