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Aggregate Demand Curve

Aggregate demand curve shows, for each price level, the associated level of GDP for which aggregate desired spending equals total output, and is consistent with the level of income generated at that output. The aggregate demand (AD) curve shows the inverse relationship between the price level and GDP. A changed in the price level changes GDP in the opposite direction, all other exogenous variables such as government spending, tax rates, investment spending and exports remaining unchanged. To derive the aggregate demand curve first we shall have to understand the behaviour of response of the aggregate spending curve to the changes in the domestic price level.

Aggregate Spending Curve

The price level and desired aggregate spending are negatively related to each other. A rise in the price levels shift the aggregate spending curve downwards, while a fall in the price level shifts it upwards. This shift takes place due mainly to changes in: (A) private consumption spending, and (B) desired net exports.

Changed in the Private Consumption: The major factor that cause change in desired consumption for price level changes is Wealth. People can hold wealth in the form of money (cash) or financial instruments such as government bonds.

A change in the domestic price level changes the value of all assets. A change in the price level has the opposite effect on the holder of an asset than on the issuer of the assets. There are two types of assets: (a) inside assets, and (b) outside assets.

(a) Inside Assets: These are the assets which are issued in the private sector and held by someone else in the private sector itself. For an inside assets a rise in the domestic price level lowers the real wealth of a bond holder, while it raises the real wealth of the bond issuer, because he will have to a part with lesser purchasing power when the bond is redeemed. In brief, a rise in the domestic price level cause a decrease in the real wealth of a person who owns an asset and raise the real wealth of the person who has to redeem the asset. Cumulatively, in case of inside assets a change in the domestic price level has no effect on private sector’s wealth.

(b) Outside Assets: These are the assets which are held by persons in the private sector but their issuer may be the governmental any foreign agent. In this case the effect of a domestic price change falls only on the persons in the private sector but not on the issuer of bonds.

In brief, a change in the domestic price level causes no net change in the wealth of the private sector with respect to inside assets, but it does cause a change with respect to outside assets since the issuers are not in the private sector.