Page 689 - The Principle of Economics

interest rates. Lower interest rates, in turn, encourage borrowing by firms that want to invest in new plants and equipment and by households who want to in- vest in new housing. Thus, a lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded.
The Price Level and Net Exports: The Exchange-Rate Ef- fect As we have just discussed, a lower price level in the United States lowers the U.S. interest rate. In response, some U.S. investors will seek higher returns by investing abroad. For instance, as the interest rate on U.S. government bonds falls, a mutual fund might sell U.S. government bonds in order to buy German govern- ment bonds. As the mutual fund tries to move assets overseas, it increases the sup- ply of dollars in the market for foreign-currency exchange. The increased supply of dollars causes the dollar to depreciate relative to other currencies. Because each dollar buys fewer units of foreign currencies, foreign goods become more expen- sive relative to domestic goods. This change in the real exchange rate (the relative price of domestic and foreign goods) increases U.S. exports of goods and services and decreases U.S. imports of goods and services. Net exports, which equal ex- ports minus imports, also increase. Thus, when a fall in the U.S. price level causes U.S. interest rates to fall, the real exchange rate depreciates, and this depreciation stimulates U.S. net exports and thereby increases the quantity of goods and services demanded.
Summary There are, therefore, three distinct but related reasons why a fall in the price level increases the quantity of goods and services demanded: (1) Con- sumers feel wealthier, which stimulates the demand for consumption goods. (2) Interest rates fall, which stimulates the demand for investment goods. (3) The ex- change rate depreciates, which stimulates the demand for net exports. For all three reasons, the aggregate-demand curve slopes downward.
It is important to keep in mind that the aggregate-demand curve (like all de- mand curves) is drawn holding “other things equal.” In particular, our three ex- planations of the downward-sloping aggregate-demand curve assume that the money supply is fixed. That is, we have been considering how a change in the price level affects the demand for goods and services, holding the amount of money in the economy constant. As we will see, a change in the quantity of money shifts the aggregate-demand curve. At this point, just keep in mind that the aggregate-demand curve is drawn for a given quantity of money.
WHY THE AGGREGATE-DEMAND CURVE MIGHT SHIFT
The downward slope of the aggregate-demand curve shows that a fall in the price level raises the overall quantity of goods and services demanded. Many other fac- tors, however, affect the quantity of goods and services demanded at a given price level. When one of these other factors changes, the aggregate-demand curve shifts.
Let’s consider some examples of events that shift aggregate demand. We can categorize them according to which component of spending is most directly affected.
Shifts Arising from Consumption Suppose Americans suddenly be- come more concerned about saving for retirement and, as a result, reduce their current consumption. Because the quantity of goods and services demanded at
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 709