THE DOWNWARD SLOPE OF THE AGGREGATE DEMAND CURVE

Having seen how the theory of liquidity preference explains the economy’s equilibrium interest rate, we now consider its implications for the aggregate demand for goods/ and services. As a warm-up exercise, let’s begin by using the theory to reexamine a topic we already understand–the interest-rate effect and the downward slope of the aggregate-demand curve. In particular, suppose that the overall level of prices in the economy rises. What happens to the interest rate that balances the supply and demand for money, and how does that change affect the quantity of goods and services demanded? As we discussed in Chapter 30, the price level is one determinant of the quantity of money demanded. At higher prices, more money is exchanged every time a good or service is sold. As a result, people will choose to hold a larger quantity of money. That is, a higher price level increases the quantity of money demanded for any given interest rate. Thus, an increase in the price level from PI to P2 shifts the money demand curve to the right from MDI to MD2′ as shown in panel (a) of Figure 2.

The Money Market and the Slope of the Aggregate-Demand Curve

An increase in the price level from PI to P2 shifts the money-demand curve to the right, as in panel (a). This increase in money demand causes the interest rate to rise from ‘I to T2• Because the interest rate is the cost of borrowing, the increase in the interest rate reduces the quantity of goods and services demanded from Y1to Y2• This negative relationship between the price level and quantity demanded is represented with a down ward sloping aggregate-demand curve, as in panel (b).

Notice how this shift in money demand affects the equilibrium in the money market. For a fixed money supply. the interest rate must rise to balance money supply and money demand The hizher price level has increased the amount of money people want to hold and has shifted the money demand eurve to the right  Yet the quantity of money supplied is unchanged, so the interest rate must rise from rl to r2 fo discourage the additional demand. This increase in the interest rate has ramifications not only for the money market but also for the quantity of goods and services demanded, as shown in panel (b). At a higher interest rate, the cost of borrowing and the return to saving are greater. Fewer households choose to borrow to buy a new house  and those who do buy smaller houses, so the demand for residential investment falls. Fewer firms choose to borrow to build new factories and buy new equipment, so business investment falls. Thus, when the price level rises from PI to P2, increasing money demand from MDI to MD2 and raising the interest rate from rl to r2, the quantity of goods and services demanded falls from Yt to Y2• This analysis of the interest-rate effect can be summarized in three steps: (1) A higher price level raises money demand. (2) Higher money demand leads to a higher interest rate. (3) A higher interest rate reduces the quantity· of goods and services demanded. Of course, the same logic works in reverse as well: A lower price level reduces money demand, which leads to a lower interest rate, and this in turn increases the quantity of goods and services demanded. The end result of this analysis is a negative relationship between the price level and the quantity of goods and services demanded, as illustrated  ward sloping aggregate-demand curve.