Economics explained
Category:
The macroeconomy
The aggregate demand and price level
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Why does aggregate demand fall when the price level rises and vice versa? There are three reasons:
The wealth effect:
A rise in the price level will reduce the amount of goods and services that people’s wealth can buy. The purchasing power of savings held in the form of bank accounts and other financial assets will fall.
The international effect:
A rise in the price level will reduce demand for net exports as exports will become less price competitive while imports will become more price competitive.
The interest rate effect:
A rise in the price level will increase demand for money to pay the higher prices. This, in turn, will increase the interest rate. A higher interest rate usually results in a reduction in consumption and investment.