Along the aggregate demand curve AD2 curve, as the price level rises from 0.5 to

Question

Along the aggregate demand curve AD2 curve, as the price level rises from 0.5 to 1.5, th equantity of real output demanded declines from $3,000 billion to $2,000 billion. What happens to the aggregate quantity demanded in nominal terms over this interval? Using the formula for price elasticity of demand (the ratio of the percentage change in the quantity of a good demanded to a given percentage change in the quantity of a good demanded to given percentage change in its price), what is the elasticity of aggregate demand over this interval?

Explanation / Answer

Our examination of real values of consumption, investment, government purchases, and net

exports indicates that each component of real aggregate demand varies inversely with the price

level. We conclude, then, that the aggregate demand curve as a whole must have a negative

slope,

It is sometimes useful to know the elasticity of a demand curve as well as whether its slope is

positive or negative. For reasons that will be explained more fully in coming chapters, we will

draw aggregate demand curves that are relatively inelastic with respect to changes in the average

price level. This means that a given percentage change in the price level will cause a smaller

percentage change in the level of real planned expenditure.

The price elasticity of demand for a single good determines what happens to revenues from

sale of the good as its price changes. When the demand for a good is relatively elastic, an

increase in its price will cause revenue to decrease, because a given percentage increase in the

price will not increase the amount of revenue per unit enough to offset the larger percentage

reduction in units sold. When demand is relatively inelastic, an increase in price will cause

revenue to increase, because a given price increase will have a relatively small effect on the

number of units sold.

Using similar reasoning, we can show that the elasticity of the aggregate demand curve

determine how nominal aggregate demand is affected by a change in the average price level.

Nominal aggregate demand means total demand for all final goods and services stated in terms

of the prices at which they are actually sold. Nominal aggregate demand is equal to real

aggregate demand times the price level. If aggregate demand is relatively inelastic, a given

percentage increase in the price level will cause a smaller percentage decrease in real aggregate

demand. As a result, nominal aggregate demand tends to increase as we move upward along a

relatively inelastic aggregate demand curve.

Consider, for example, the aggregate demand curve in Figure 7.1. This curve is relatively

inelastic along the segment from point A to point B.1

At point A the price level is 0.5 and the

quantity of real domestic product demanded is $2,000 billion. Nominal aggregate demand at

point A thus is 0.5

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