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Monday, 20 September 2021

More on "aggregate demand curve, but why?"

   In my last post, I mention the explanation for why individual demand curve is downward sloping in a Edexel AS/AL textbook. This book also explains why aggregate demand curve is downward sloping. Interestingly, its explanation is almost the same as the version that I have criticized in my past post.
   "Demand curve is nearly always downward sloping. Why is the aggregate demand curve the same shape? One simple answer is to consider what happens to a household budget if prices rise. If a household is on a fixed income, then a rise in average prices will mean that they can buy fewer goods and services than before. The higher the price level in the economy, the less they can afford to buy. So it is with the national economy".
   In my past post, I have explained: the fixed income assumption that is valid for any single individuals may not be valid for the whole economy. Put it simply, a higher price reduces the good buyers' purchasing power with a fixed income. But a higher price also increases the purchasing power of the good seller with more sale revenue obtained. Thus, the explanation based on fixed income is not valid.
   Meanwhile, the book is not completely wrong as it immediately adds, after the above (invalid) explanation that there is a more sophisticated explanation (by assessing components of GDP: consumption, investment, government spending, and exports and imports). It turns out that these "more sophisticated" explanations do not rely on the "fixed income" assumption and are thus more likely valid. However, if the book can list out these explanations, why it chooses to mention the "fixed income" one, which is invalid?
   For the "more sophisticated" explanations, the consumption and investment reasons rely on interest rates, and so is similar to the reason offered in my past post. The government spending is unaffected by price. The export-import reason is related to competitiveness of export goods relative to imported goods, and is intuitively understandable. When discussing why consumption will be depressed by prices, it also mentions wealth effect. I have remarked in my past post that wealth effect is not a straightforward issue. The explanation about wealth effect offered in this book cannot completely clear my doubt though it is not too bad. All in all, I think there is much scope for improvement in the explanation of aggregate demand.

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