The Slope of the Aggregate Demand Curve
Due to Pigou's Wealth Effect, the Keynes' Interest Rate Effect, and the MundellFleming Exchange Rate Effect, the AD curve slopes downward.
Learning Objective

Explain the factors that influence the slope of the aggregate demand curve
Key Points
 Pigou's Wealth Effect, the Keynes' Interest Rate Effect, and the MundellFleming Exchange Rate Effect are all theoretical inputs that reaffirm a downwards slope for aggregate demand (AD).
 The critical takeaway from Keynes's perspective on the slope of the aggregate demand curve is that interest rates affect expenditures more than they affect savings. As a result, insufficient AD is not sustainable in a given system.
 The simplest way to put to wealth effect is that an increase in spending will denote an increase in wealth.
 Robert Mundell and Marcus Fleming noted that incorporating the nominal exchange rate into the mix makes it impossible to maintain free capital movement, a fixed exchange rate and independent monetary policy.
 While these varying effects make the concept of aggregate demand slopes seem somewhat complicated, the most important thing to keep in mind is that people will be demanding more goods when they are cheaper.
Term

liquidity trap
Injections of cash into the private banking system by a central bank fail to lower interest rates and stimulate economic growth.
Full Text
Aggregate demand (AD) is the total demand for all goods within a given market at a given time, or the summation of demand curves within a system. Understanding the basic graphical representation of this curve is useful in grasping the implications of AD on an economic system, as well as the distinct effects which drive it. As a result of Keynes' interest rate effect, Pigou's wealth effect, and the MundellFleming exchange rate effect, the AD curve is downward sloping.
Keynes' Interest Rate Effect
The critical point from Keynes's perspective on the slope of the aggregate demand curve is that interest rates affect expenditures more than they affect savings. If prices fall, a given amount of money will increase in value. This will drive up interest rates and investments. It is important to note that insufficient demand in a market will not go on forever.
In understanding this fully, it is useful to look at an ISLM graph (see ). There are only two times when the Keynes observation on the interest rate effect will be inaccurate, and that is if the IS (investment savings) curve were to be vertical or if the LM (liquidity preference money supply) curve were to be horizontal. This makes sense if you think about it, it would basically equate to a liquidity trap. A vertical IS curve or a horizontal LM curve would essentially negate the way in which interest rates could affect aggregate demand.
ISLM Model
The ISLM model takes investments and savings and compares that to liquidity and the overall money supply. It is highly useful in understanding macroeconomics from a Keynesian perspective. Interest rates (i) are on the vertical axis, and output (y) is on the horizontal axis.
Pigou's Wealth Effect
In the context of the above discussion on Keynes, Pigou's Wealth Effect underlines the fact that liquidity traps are not sustainable. The simplest way to explain the Wealth Effect is that an increase in spending will denote an increase in wealth. In many ways, what Pigou is putting forward is the idea that downwards spiral on the ISLM model , as predicted by Keynes due to deflation, will be counterbalanced by an increase in real wages and thus an increase in expenditure. In other words, a decrease in employment and prices will eventually see higher purchasing power and an increase in spending, creating wealth.
MundellFleming Exchange Rate Effect
Perhaps the most complex of the three inputs underlined in deriving aggregate demand is the MundellFleming Exchange Rate Effect. Just like the previous two, this builds off of the ISLM model in a way that discusses it in the context of an open economy (as opposed to a closed system). It essentially takes into account a new factor (in addition to interest rates and outputs, as the traditional ISLM model incorporates). This new factor is the exchange rates, as the name implies. Robert Mundell and Marcus Fleming noted that incorporating the nominal exchange rate into the mix makes it impossible to maintain free capital movement, a fixed exchange rate and independent monetary policy. This is sometimes referred to as the 'impossible trinity,' implying that tradeoffs must be made. This concept is illustrated fairly well in this figure , where 'FE' is fixed expenditure.
MundellFleming Fixed Exchange Rate Illustration
An increase in government spending forces the monetary authority to supply the market with local currency to keep the exchange rate unchanged. Shown here is the case of perfect capital mobility, in which the BoP curve (or, as denoted here, the FE curve) is horizontal.
Conclusion
While these varying effects make the concept of aggregate demand slopes seem somewhat complicated, the most important thing to keep in mind is that people will be demanding more goods when they are cheaper. The analysis of interest rates displayed above, through the wealth effect in particular, offsets the negative spiral that could occur as a result of deflation and decreased employment. These effects also play a crucial role in understanding the way in which the larger and more complex environment, including investments and fiscal and monetary policy, will retain this downwards slope.
Key Term Reference
 Tradeoffs
 Appears in these related concepts: Scarcity Leads to Tradeoffs and Choice, Introducing the Budget Constraint, and Changes in Equilibrium for Shifts in Market Supply and Market Demand
 Wealth Effect
 Appears in this related concept: Impact of Income on Consumer Choices
 aggregate
 Appears in these related concepts: Supply Schedules and Supply Curves, General Strengths and Limitations of Trait Perspectives, and Reinforced Concrete Construction
 aggregate demand
 Appears in these related concepts: The Importance of Aggregate Decisions about Consumption versus Saving and Investment, Graphing Equilibrium, and Effect of a Government Budget Deficit on Investment and Equilibrium
 capital
 Appears in these related concepts: Temple Architecture in the Greek Orientalizing Period, Minoan Architecture, and The Acropolis
 deflation
 Appears in these related concepts: Growth Economics, Macroeconomics, and Bernanke Era
 demand
 Appears in these related concepts: Addressing Market Needs, Definition of Price Elasticity of Supply, and Applications of Elasticities
 demand curve
 Appears in these related concepts: Impacts of Supply and Demand on Pricing, Marginal Analysis, and Willingness to Pay and the Demand Curve
 exchange rate
 Appears in these related concepts: Exchange Rates, International Exchange of Money, and Introducing Exchange Rates
 expenditure
 Appears in these related concepts: Capital Expenditures, The Circular Flow Model, and Introducing Aggregate Demand
 fixed exchange rate
 Appears in these related concepts: Exchange Rate Policy Choices, Exchange Rate Systems, and Fixed Exchange Rates
 input
 Appears in these related concepts: Defining Productivity, A Study of Process, and Changes in Technology Over Time
 interest rate
 Appears in these related concepts: Greenspan Era, The Financial Account, and Determinants of investment
 investment
 Appears in these related concepts: Functions of Corporate Finance, The Role of the Financial System, and GDP Equation in Depth (C+I+G+X)
 liquidity
 Appears in these related concepts: Impact of Modifying Inputs on Business Operations, Consequences of Banking Crises, and The Federal Reserve and the Financial Crisis of 2008
 monetary policy
 Appears in these related concepts: Keynesian Theory, The Reserve Ratio, and Trends in Credit After 2008
 nominal
 Appears in these related concepts: Calculating Real GDP, Explaining Fluctuations in Output, and Impacts of Policies and Events on Equilibrium
 nominal exchange rate
 Appears in this related concept: Real Versus Nominal Rates
 output
 Appears in these related concepts: Functions and Their Notation, Defining the Production Function, and Introducing Aggregate Supply
 price
 Appears in these related concepts: BreakEven Analysis, Terms Used to Describe Price, and Defining a Market System
 purchasing power
 Appears in these related concepts: Consumer Income, Purchasing Power, and Confidence, Defining and Measuring Poverty, and The Costs of Inflation
 sustainable
 Appears in these related concepts: Basic Economics of Natural Resources, Defining and Measuring Income Inequality, and Causes of Market Failure
Sources
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