Question

On a microeconomic demand curve, a decrease in price causes an increase in quantity demanded because the product in question is now relatively less expensive than substitute products. Explain why aggregate demand does not increase for the same reason in response to a decrease in the aggregate price level. In other words, what causes total spending to increase if it is not because goods are now cheaper?

a) Aggregate demand is influenced by factors other than price alone.
b) Decreased prices do not affect consumer behavior at the macroeconomic level.
c) The wealth effect and interest rates impact aggregate demand.
d) Aggregate demand increases solely due to cheaper goods.

Answer 1

Aggregate demand does not increase solely due to reduced aggregate price levels because of the wealth effect, interest rates, and the foreign price effect, which influence total spending and investment differently than microeconomic price changes.

Step-by-step explanation:

On a microeconomic demand curve, a decrease in price causes an increase in quantity demanded because individuals perceive the product to be less expensive relative to substitute goods. However, in macroeconomics, the concept of aggregate demand encompasses more than just price levels. Unlike an individual product, when the overall aggregate price level decreases, it does not necessarily lead to an increased aggregate demand for the same reasons as in microeconomic demand curves.

The reasons for an increase in total spending at the macroeconomic level can be attributed to factors such as the wealth effect, interest rates, and the foreign price effect. The wealth effect suggests that when the price level falls, consumers feel wealthier due to the increased purchasing power of their money, thereby potentially increasing consumption. Similarly, lower interest rates can lead to higher investment spending. Lastly, a lower price level can make domestic goods more competitive in foreign markets, boosting exports.

However, these effects, as mentioned, are often controversial among economists and can be small in magnitude. Consequently, the downward slope of the aggregate demand curve is relatively steep, indicating that while a higher price level does reduce aggregate demand, changes in the quantity of aggregate demand in response to changes in the price level are not typically very large.