What determines aggregate demand?

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1) The Wealth Effect: A higher price level reduces the purchasing

power of financial wealth. Assets such as stocks, bonds, cash, and

checking account balances are worth less, which shrinks the amounts

you can buy. Thus, higher average prices reduce the amount of

domestic production sold along an Aggregate Demand curve.

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2) The Foreign-Sector Substitution Effect (real exchange rate

effect): Higher prices cause domestic consumers to buy more imports

and fewer domestic goods. Foreign buyers respond similarly,

shrinking our exports.

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Investment is affected in a similar fashion. Hikes in the price

level drive up domestic production costs. A higher price level

shrinks investment both foreign and domestic, firms would find it

relatively more profitable to invest abroad. In sum, trends toward

imports and foreign investments reinforce the wealth effect in

making Aggregate Demand curves negatively sloped.

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3) The Interest Rate Effect (intratemporal effect): The amount of

borrowing required to finance a major purchase rises if the price

level rises. A higher price level increases the demand for loanable

funds and, consequently, increases the interest rate, which is the

cost of credit. This increase in interest rates reduces investment

and such consumer purchases as new homes, cars, or appliances. The

figure below summarizes how these effects cause movements along

Aggregate Demand curves as the price level changes.