Q4. What is the aggregate demand (AD) curve? Why does it slope downwards? What might cause it to shift outwards?
The Aggregate Demand (AD) curve is the combination of price level (P) and output (Y) consistent with equilibrium in the money market. It represents the demand side of the classical model of equilibrium in the economy.
It can be derived from the quantity theory of money which can be written as:
MV = PY
where M = money supply in the economy (controlled by the central bank); P = general price level; V = technical parameter representing the velocity of money; Y = real output in the economy.
When the price level increases and we assume constant money supply (the central bank does not intervene), a disequilibrium in the money market appears: there is a decrease in real money balances M/P. In other words, agents in the economy have less purchasing power and are forced to diminish the number of transactions in order to restore the equilibrium. Output goes down to match the shortage of demand and the AD results downward sloping: when prices go up, output goes down.
While the slope of the AD depends on the negative relationship between P and Y, its position in the quadrant is determined by several other factors:
i) Money supply. An expansionary monetary policy increases real money balances providing more money for transaction purposes. That is, for a given output, prices rise to restore equilibrium or, for a given price level, output increases to match higher demand: the AD shifts outwards.
ii) Velocity of money. An increase in the velocity of money means that economic agents have more money available in the unit of time, being this situation similar to an increase in real money balances: the AD shifts outwards.
iii) Expectations on the future. An improvement of business expectations leads to higher investment, which is a component of the AD, shifting the curve outwards.
iv) Being the AD = private consumption + private investment + government spending, also an increase in the marginal propensity to consume and an expansionary fiscal policy shift the curve outwards.
v) A decrease in the interest rate affects AD position indirectly, changing the pattern of the three components of AD: it increases private consumption because it reduces its opportunity cost (less remuneration of saving); it increases private investment because it reduces the cost of borrowing money, rendering new investments more profitable; it reduces the cost of public debt, rendering more resources available for the government for current and capital spending. The AD shifts outwards.