8/3/2019 Macro Chp. 12

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Molly Robbins

Mr. Hasten 1st

AP Macroeconomics20 January 2010

Chapter 12 Questions

1. The aggregate demand curve is represented as an inverse relationship between theprice level and the quantity of real GDP demanded. This means that when the price level

increases, the GDPr decreases, and vice-versa. The curve is downsloping for three

reasons: (1) the real-balances effect, (2) the interest-rate effect, and (3) the foreignpurchases effect. The real-balances effect is evident when there is an increase in the price

level, which forces an economy to purchase fewer goods and services. Also, the real

value of assets with fixed money values, like savings accounts, diminishes, causing the

public to be poorer in real terms and reduce purchasing power. When considering the ADcurve, it is assumed that the supply of money is fixed, so, an increase in money demand

will drive up the price paid for its use; that price is the interest rate. In the interest-rate

effect, when the price level rises, there is a greater demand of money needed for

purchases and the high interest rates reduce investment spending. This causes a higherprice level, which diminishes the real output demanded. Thirdly, in the foreign purchases

effect, as the U.S. price level increases comparative to foreign price levels, foreigners buyfewer U.S. goods and Americans buy more foreign good. Consequently, the rise in the

price level reduces the quantity of U.S. goods demanded as net exports.

The explanation for the downsloping demand and aggregate demand curves are

very different. The downsloping demand curve is caused, by three very different reasons.First, the concept of marginal utility, the more you consume something the less of it you

will enjoy. Second, it is focused on the income and substitution effect, and third, if the

price of the product changes, consumers will have more or less purchasing power. Thedownsloping demand curve only measures the demand for one product, while the AD

curve measures the sum of everything produced. For example, when moving down anAD curve, all of the prices in the economy are dropping, while in the demand curve, onlythe price of that specific product is dropping.

The effect that the multiplier has on the aggregate demand curve is that it is an

initial change in spending and it produces an even greater shift in the AD curve.

2. The real-balances effect is the tendency for increases in the price level to lower the

real value, or purchasing power, of financial assets with fixed money value and, as a

result, to reduce total spending and real output, and conversely for decreases in the pricelevel. So, if the price level declines, the purchasing power of assets will rise, resulting in

an increase in spending because peoples savings are more valuable. The real-balances

effect is one of the reasons for the downward sloping line in the aggregate demandcurve. The wealth effect is the tendency for people to increase their consumption

spending when the value of their financial and real assets rise and to decrease their

consumption spending when the value of those assets fall. When there is an increase inconsumer spending, the AD curve shifts right, conversely, when there is an unexpected

decline in asset values there is a decline in consumer wealth at each price level, shifting

the AD curve to the left.