AGGREGATE DEMAND (AD, for short) = C + I + G + (X-M)
• The aggregate demand curve is not focused on a single good or service. The AD curve is focused on overall demand for all final goods & services produced across the entire economy.
• Determinants of Aggregate Demand: Although the shape of the AD curve is similar to the shape of a single market demand curve, its shape is based on entirely different principles from what we studied in Chapter 3. To elaborate,
• Single market demand curves are controlled by relative prices, whereas aggregate demand curves respond to general price levels. We are accustomed to downward sloping demand curves. At higher prices, the quantity demanded of a product is going to be less than at lower prices. But remember, the law of demand is based on relative prices. For instance, an increase in the price of coca-cola raises its price relative to its substitute, Pepsi, so consumers will switch their purchases from Coca-cola to cheaper substitutes like Pepsi. Aggregate demand curves, however, reveal how aggregate demand responds to changes in the GENERAL PRICE LEVEL. • Higher prices do not cause aggregate demand to fall. Why? Because when price levels rise, wages also tend to rise along with prices. All boats tend to float, so to speak. Substitutions will be made for those things whose prices are rising more rapidly than others, but in the aggregate, there is no decrease in aggregate demand.
• Definition: The aggregate demand curve shows the quantities of total output (GDP) economic agents in the economy are prepared to buy at different price levels.
Remember that there are four types of spending on final goods and services: personal consumption expenditures (C ), investment expenditures (I), government purchases of goods and services (G), and net exports (X '' M). Aggregate demand therefore equals the real amounts of C + I + G + (X '' M) that economic agents wish to purchase at different price levels. If an increase in the price level (P) causes economic agents throughout the economy to reduce their real spending on any of these expenditure categories, then the AD curve will have a downward slope.
Reasons why C + I + G + (X '' M) falls as price levels rise:
1. Real balance effect (or purchase power effect): As the price level rises, the purchasing power of wealth & income falls. For example: A family has net assets worth $50,000. Assume their income remains constant. If prices rise, the purchasing power of that $50,000 falls. Same reasoning behind inflation’s redistributive effect applies here. When consumers’ wealth falls, they will tend to feel “poorer,” so consumption will fall. As consumption falls, GDP or output will also fall. So, the AD curve falls or shifts left.
Conversely, if consumer wealth increases, consumption rises. If consumption rises, GDP or output rises. So, the AD curve will also rise or shift right.
2. Interest rate effect: As the price level rises, the demand for credit increases. Why? Because it takes more money to buy goods and services. People will therefore tend to borrow more money to finance their purchases. The increased demand for credit causes interest rates to rise. The down-side to rising interest rates is that it discourages business investment. Thus, as prices rise, interest rates rise, investments fall, and a smaller quantity of output or real GDP is demanded & supplied. In sum, as interest rates rise, investments fall. As investments fall, GDP falls '' so the AD curve will fall or shift to the left.
Conversely, as interest rates fall, investments rise. As investments rise, GDP rises. When GDP rises, AD curve rises or shifts right.
3. Foreign Trade Effect: As the domestic price level rises relative to foreign price levels, domestic goods become more expensive relative to foreign goods. Consumer demand for domestically produced goods...