Aggregate Demand

Introduction

Aggregate demand (AD) shows the relationship between real gross domestic product (GDP) and the price level in the economy. The AD curve has a negative slope, showing that as the price level increases, real GDP decreases, and as the price level decreases, real GDP increases. The negative relationship between the price level and real GDP is explained by three different things that happen when the price level changes in the economy. When the price level changes, it affects consumers’ purchasing power, interest rates paid by consumers and business, and the relative prices of domestic goods and services compared to imported goods and services.

The effect of a change in the price level on consumers’ purchasing power is called the wealth effect. The effect of a change in the price level on interest rates (and therefore interest-sensitive spending by consumers on things like houses and cars and investment spending by businesses) is called the interest rate effect. The effect of a change in the price level on imports and exports in called the net export effect. The three effects explain why the AD curve has a negative slope.

Watch the video below to get an overall idea of aggregate demand.

Aggregate Demand

Firms face four sources of demand: households (personal consumption), other firms (investment), government agencies (government purchases), and foreign markets (net exports). Aggregate demand is the relationship between the total quantity of goods and services demanded (from all the four sources of demand) and the price level, all other determinants of spending unchanged. The aggregate demand curve is a graphical representation of aggregate demand.

The Slope of the Aggregate Demand Curve

Aggregate Demand Curve Example We will use the implicit price deflator as our measure of the price level; the aggregate quantity of goods and services demanded is measured as real GDP. The table provided gives values for each component of aggregate demand at each price level for a hypothetical economy. Various points on the aggregate demand curve are found by adding the values of these components at different price levels.

The aggregate demand curve for the data given in the table is plotted on the graph.

At point A, at a price level of 1.18, $11,800 billion worth of goods and services will be demanded; at point C, a reduction in the price level to 1.14 increases the quantity of goods and services demanded to $12,000 billion; and at point E, at a price level of 1.10, $12,200 billion will be demanded.

The negative slope of the aggregate demand curve suggests that it behaves in the same manner as an ordinary demand curve. But we cannot apply the reasoning we use to explain downward-sloping demand curves in individual markets to explain the downward-sloping aggregate demand curve. There are two reasons for a negative relationship between price and quantity demanded in individual markets. First, a lower price induces people to substitute more of the good whose price has fallen for other goods, increasing the quantity demanded. Second, the lower price creates a higher real income. This normally increases quantity demanded further.

Neither of these effects is relevant to a change in prices in the aggregate. When we are dealing with the average of all prices—the price level—we can no longer say that a fall in prices will induce a change in relative prices that will lead consumers to buy more of the goods and services whose prices have fallen and less of the goods and services whose prices have not fallen. The price of corn may have fallen, but the prices of wheat, sugar, tractors, steel, and most other goods or services produced in the economy are likely to have fallen as well.

Furthermore, a reduction in the price level means that it is not just the prices consumers pay that are falling. It means the prices people receive—their wages, the rents they may charge as landlords, the interest rates they earn—are likely to be falling as well. A falling price level means that goods and services are cheaper, but incomes are lower, too. There is no reason to expect that a change in real income will boost the quantity of goods and services demanded—indeed, no change in real income would occur. If nominal incomes and prices all fall by 10%, for example, real incomes do not change.

Why, then, does the aggregate demand curve slope downward?

Click on each of the effects below to learn more about how they effect the demand curve.

Taken together, then, a fall in the price level means that the quantities of consumption, investment, and net export components of aggregate demand may all rise. Since government purchases are determined through a political process, we assume there is no causal link between the price level and the real volume of government purchases. Therefore, this component of GDP does not contribute to the downward slope of the curve.

Watch the presentation below to learn more about aggregate demand.

Just as demand and supply yield the price and quantity of a particular product, Aggregate Demand (AD) & Aggregate Supply (AS) determine the macroeconomic equilibrium - price level (telling whether we have inflation), quantity of goods and services (real GDP), and, indirectly unemployment.

Watch the video below to learn how these all work together.

Review

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In Summary . . .

What's Your takeaway? Icon Potential output is the level of output an economy can achieve when labor is employed at its natural level. When an economy fails to produce at its potential, the government or the central bank may try to push the economy toward its potential.

The aggregate demand curve represents the total of consumption, investment, government purchases, and net exports at each price level in any period. It slopes downward because of the wealth effect on consumption, the interest rate effect on investment, and the international trade effect on net exports.

The aggregate demand curve shifts when the quantity of real GDP demanded at each price level changes.

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