Answer to Question #32133 in Macroeconomics for kyron regis

Question

How do falling interest rates and falling prices influence total demand in the economy? Include the “wealth effect” in your answer

Answer 1

There are three basic reasons for the downward sloping aggregate demand curve. These are Pigou's wealth effect, Keynes's interest-rate
effect, and Mundell-Fleming's exchange-rate effect. These three reasons for the
downward sloping aggregate demand curve are distinct, yet they work together.

The first reason for the downward slope of the aggregate demand curve is Pigou's wealth effect. Recall that the nominal value of money is fixed, but the
real value is dependent upon the price level. This is because for a given
amount of money, a lower price level provides more purchasing power per unit of
currency. When the price level falls, consumers are wealthier, a condition
which induces more consumer spending. Thus, a drop in the price level induces
consumers to spend more, thereby increasing the aggregate demand.

The second reason for the downward slope of the aggregate demand curve is Keynes's interest-rate effect. Recall that the quantity of money demanded is
dependent upon the price level. That is, a high price level means that it takes
a relatively large amount of currency to make purchases. Thus, consumers demand
large quantities of currency when the price level is high. When the price level
is low, consumers demand a relatively small amount of currency because it takes
a relatively small amount of currency to make purchases. Thus, consumers keep
larger amounts of currency in the bank. As the amount of currency in banks
increases, the supply of loans increases. As the supply of loans increases, the
cost of loans--that is, the interest rate--decreases. Thus, a low price level induces
consumers to save, which in turn drives down the interest rate. A low interest
rate increases the demand for investment as the cost of investment falls with
the interest rate. Thus, a drop in the price level decreases the interest rate,
which increases the demand for investment and thereby increases aggregate
demand.

The third reason for the downward slope of the aggregate demand curve is Mundell-Fleming's exchange-rate effect. Recall that as the price level falls
the interest rate also tends to fall. When the domestic interest rate is low
relative to interest rates available in foreign countries, domestic investors
tend to invest in foreign countries where return on investments is higher. As
domestic currency flows to foreign countries, the real exchange rate decreases
because the international supply of dollars increases. A decrease in the real
exchange rate has the effect of increasing net exports because domestic goods
and services are relatively cheaper. Finally, an increase in net exports increases
aggregate demand, as net exports is a component of aggregate demand. Thus, as
the price level drops, interest rates fall, domestic investment in foreign
countries increases, the real exchange rate depreciates, net exports increases,
and aggregate demand increases.