4 Key Questions About Aggregate Demand
4/11/2024 Jacob Reed
In this article we are going to begin to explore the Aggregate Supply and Aggregate Demand model (also known as the AS/AD model) of the macroeconomy. This model is very similar to supply and demand, except that we aren’t looking at supply and demand for just one good or service, rather supply and demand for all goods and services within an entire economy. Below, you will learn everything you need to know about aggregate demand. In the next article, you will learn about aggregate supply. Then, we will combine them, to more fully understand the aggregate economy.
1. What is aggregate Demand?
Aggregate demand is the total demand for all goods and services within an entire economy. Just like demand curves for individual products, aggregate demand is downward sloping. But instead of an inverse relationship between price and quantity, aggregate demand shows the inverse relationship between the price level and the quantity of real GDP demanded within the economy. That means when it comes to the graph, the y-axis will be labeled price level (or PL), and the x-axis will be labeled real GDP (or rGDP).
The x-axis is also known as real output, national income, and it correlates to the level of employment (the opposite of unemployment) within an economy. The downward slope tells us at higher price levels, a lower quantity of real GDP will be demanded, and at lower price levels a higher quantity of real GDP will be demanded.
2. Why is aggregate demand downward sloping?
There are 3 reasons why there is an inverse relationship between the price level and the quantity of real GDP demanded. Those reasons are the wealth effect, interest rates effect, and net export effect.
The wealth effect says at higher prices, your wealth (think monetary wealth) buys fewer goods and services. At lower prices, your wealth buys more goods and services. This is like the income effect you may have learned about in Microeconomics. Essentially people buy more goods and services within the economy when prices are low and fewer goods and services when prices are high.
The Interest rate effect is another reason for the inverse relationship between the price level and real GDP demanded. At when price levels rise nominal interest rates also rise. Higher interest rates correlate to less gross investment because businesses must pay interest to purchase physical capital (gross investment) and higher interest rates make purchasing physical capital more expensive. So higher price levels mean less gross investment and therefore less real GDP. Likewise, if price levels fall, nominal interest rates also fall. Lower interest rates make it cheaper for businesses to take out loans to purchase physical capital, which increases gross investment. That means lower price levels increase gross investment and real GDP.
The Net Export Effect is the final reason for the inverse relationship between the price level and real GDP demanded. If the US price level rises, US made goods will be more expensive for foreign consumers and foreign made goods become relatively cheaper for US consumers. That will decrease exports and increase imports (both decrease net exports). Also, if the US price level decreases, US made goods become cheaper for foreign consumers and foreign made goods will be more expensive for US consumers. That increases exports and decreases imports (and decreases net exports).
3. Does the price level change aggregate demand?
You may remember that price does not change demand; price only changes quantity demanded. Likewise, a change in the price level will not change aggregate demand, only the quantity of real GDP demanded. Changes in the price level occur when and economy has inflation or deflation as measured by the CPI or GDP deflator. Changes in the price level will cause movement up or down the aggregate demand curve, causing an inverse change in the quantity of real GDP demanded. An increase in the price level causes movement up the aggregate demand curve and a decrease in the price level causes movement down the aggregate demand curve. But those changes in the price level will not shift the aggregate demand curve.
4. What does change aggregate demand?
There are 4 determinants (shifters) of aggregate demand. The are the components of the output-expenditure formula for GDP (C+Ig+G+Xn). If any of those components increase (for a reason other than a change in the price level), aggregate demand will increase (shift to the right). If any of those components decrease, aggregate demand will decrease (shift to the left).
Consumer spending (C) is the first aggregate demand shifter. If consumers increase spending (from a decrease in taxes, increase in consumer confidence, increase in transfer payment, etc.), the aggregate demand curve will shift to the right. If consumers decrease spending on goods and services, the aggregate demand curve will shift to the left.
Changes in Goss investment (Ig) are the second aggregate demand shifts. If there is an increase in gross investment (from a increase in business confidence, decrease interest rates, etc.), aggregate demand will shift to the right. A decrease in gross investment will shift aggregate demand to the left.
The fourth aggregate demand shifter is Government Purchases (G). If the government increases spending, aggregate demand will shift to the right and if government spending decreases, aggregate demand will shift to the left.
The final aggregate demand shifter is Net Exports (Xn). Remember that net exports is exports minus imports. That means changes in exports or imports will change net exports. When net exports increse (increase in exports or decrease in imports), aggregate demand will shift to the right. When net exports decrease (decrease in exports or increase in imports), aggregate demand will shift to the left.