The demand curve shows the correlation between the price and demandof a product. Aggregate demand (AD) curve is ‘downward sloping’to signify that as price level decreases, the NI (national income)and production demanded increases. The curve is downward slopingbecause of three reasons: Mundell-Fleming exchange-rate effect,Pigou’s wealth effect, and Keynes’ interest rate (Michaillat &Saez, 2013). In the wealth effect instance, the nominal value ofmoney is static but the real value is reliant on the price levelsince for a certain sum of money, a lesser price gives people morepurchasing power per unit of money. A decrease in price levels makesconsumers to spend more thus, increasing aggregate demand.
On the other hand, based on the interest rate, a high price levelmeans that people use a comparatively large sum of currency to makeconsumptions and vice versa. When the price is low, consumers willspend small amounts thus, they will be lift with larger sums ofmoney to keep in the banks (Palley, 2014). As the sum of money in thebanks rises, loan supply rises, which decreases the costs of loans(interest rates). As such, low prices makes consumers to save more,which decreases the interest rate increasing the demand forinvestment ultimately increasing AD (Michaillat & Saez, 2013).With low price levels, the interest rate falls, which in most caseswill be low comparative to foreign countries. This will induce localinvestors to venture in foreign nations due to higher returns oninvestments. The real exchange rate will lessen as more localcurrency streams to foreign nations increasing net exports, which inturn increases AD.
The demand curve for a single good also behaves like in AD, but dueto diminishing marginal utility rather than falling prices as seen inAD (Michaillat & Saez, 2013). In addition, the AD relates toprice levels relative to real GDP while the other is for price levelin terms of amount demanded for a single product.
A multiplier is the proportion of the adjustment in the amount ofreal GDP at each level of price to the preliminary change in one ormore constituent of AD. In this regards, it increases the preliminarychanges in expenditures caused by wealth effect, interest rateeffect, and exchange-rate effect, which levels the AD curve further.
Lutz (2014) and Addison & Burton (2013) assert that the demandpull inflation occurs when AD in the economy outpaces AS (aggregatesupply) while fiscal policies refer to the utilization of governmentrevenue collection mostly taxes and expenditure mainly governmentspending to influence the economy. In this case, the AD is higherthan AS thus, the government should inhibit demand by decreasing theconsumption of goods. The way to do this is to reduce governmentspending, which decreases the amount of money in circulation leadingto decreased demand. Alternatively, the government can raise taxes,which results to a decrease in consumption in the private sectorwithout cutting government spending (Palley, 2014 Addison &Burton, 2013). Increased taxes, means that people will pay moretaxes, which decreases their purchasing power thus, decreaseddemand. A person who wishes to preserve government’s size wouldchoose tax raises as it would preserve the spending programs of thegovernment while a person who thinks the public sector is large wouldchoose reducing government spending to reduce government’s size.The ratchet effect denotes an occurrence when wages or pricesincreases due to a temporary pressure but fails to return upon theend of the pressure (Palley, 2014). As such, it suggests that pricesare not flexible downward thus, it stops prices from falling.
Addison, J. T., & Burton, J. (2013). The demise of “demand-pull”and “costpush” in inflation theory. PSL QuarterlyReview, 33(133).
Lutz, F. A. (2014). Cost-and demand-induced inflation. PSLQuarterly Review,11(44).
Michaillat, P., & Saez, E. (2013). A theory of aggregatesupply and aggregate demand as functions of market tightness withprices as parameters. National Bureau of Economic Research.
Palley, T. I. (2014). Money, fiscal policy, and interest rates: acritique of modern monetary theory. Review of PoliticalEconomy, 27(1), 1-23.