Aggregate Demand - Online Tutor, Practice Problems & Exam Prep

The Aggregate Demand and Aggregate Supply (ADAS) model explains short-run fluctuations in GDP and price levels. Aggregate demand (AD) encompasses consumption, investment, government spending, and net exports, reflecting the total demand in the economy. The downward-sloping AD curve indicates that as price levels decrease, the quantity of real GDP demanded increases due to the wealth effect, interest rate effect, and net exports. Lower prices enhance purchasing power, stimulate investment through reduced interest rates, and increase foreign demand for U.S. goods, thereby boosting overall economic activity.

AD-AS Model:Aggregate Demand

Alright. Let's start a discussion about another economic model, the aggregate demand and aggregate supply model. We're going to shorten it to the ADAS model, as you see here. The ADAS model stands for aggregate demand, aggregate supply. So we're going to start with aggregate demand. What this model attempts to explain is short-run fluctuations in GDP and price. Much of what you see here will mimic what we learned when we were discussing market demand and market supply, but now we're taking it to the economy as a whole. Instead of just talking about, say, the market for corn or the market for hamburgers, we're talking about the entire goods market in general.

Alright, let's start with a discussion about aggregate demand. All the demand there is in the economy, and we're going to call that the AD. So, we have the ADAS model. AD is the aggregate demand. Aggregate demand is closely related to our calculation of GDP. Recall that GDP is consumption plus investment plus government purchases plus net exports. Right? That's how we were defining GDP. When we talk about aggregate demand, who are the people demanding things? We've got the consumers, consuming goods and services, the firms consuming things or investing in products as well, right? Everything that's being demanded here includes the government demanding things, and foreigners demanding as well. So when we talk about aggregate demand, it follows the same rule as demand in a single market. Remember the rule that we've been using when we were talking about demand? The downward demand, the double d's. Well, guess what? It still holds true in this case.

So, the double d's. What does that tell us? Remember, downward demand. As price levels fall—and notice, this is price levels in the economy as a whole, not just the price of wheat or the price of hamburgers—it's not just one product. As price levels fall, the quantity of real GDP demanded increases. There's this inverse relationship. So, the lower the prices are, the more goods and services we're going to want. When we think of the aggregate demand curve and we look at it on the graph, it's going to look similar to the demand curve we drew in a market, except we're talking about the economy as a whole, right? On the y-axis, we're going to have the price level. So notice, it's not just the price of one good. It's the price level in the economy. Over here, we're going to have GDP, right? And it's going to be real GDP because we're talking about the amount of goods and services. We're focused on that quantity. So this GDP is kind of like quantity and the price level is kind of like price in another graph.

That's very similar to the graph we're used to. And our downward demand, it's going to look something like this. Just like it did before, we're going to have our demand curve going down like this, and this will be our aggregate demand, which we're calling AD, right? In this model, it's the AD, the aggregate demand. That should feel a little familiar from when we first studied supply and demand. Let's pause here and then we'll discuss some of the differences in how Market Demand and Aggregate Demand work.

Aggregate Demand Downward Sloping

So now that we're dealing with aggregate demand, we're going to need macroeconomic solutions for why the demand curve is going downward, as we saw above. Okay? So, at first, let's think about that single market we discussed in the early chapters where the quantity demanded falls as the price increases because customers substitute their demand for other products. However, when thinking about all products in the economy, we can't separate apples from oranges anymore. Aggregate demand, which includes all products, shows no substitution effect because it encompasses everything.

Aggregate demand is closely related to GDP, encompassing the total amount of things demanded in society, not just apples or oranges, but everything. It's affected by consumption, investment, government spending, and net exports. Let's start with consumption. The wealth effect explains why there is downward demand because when prices change, we can't buy as many goods. This is similar to the income effect discussed in market demand. As price levels decrease, the real value of money increases, allowing for more goods to be purchased, thus increasing quantity demanded.

Next, let’s talk about investment and its relation to the interest rate effect. As prices decrease, households can save more, which increases the supply of savings in the financial system, leading to lower interest rates. Consequently, as interest rates fall, investment spending increases, demonstrating the chain effect of lower prices leading to higher demand through increased investment.

The government spending component will be discussed later in chapters about fiscal policy. However, net exports are directly affected by price levels. As U.S. prices decrease, U.S. goods become cheaper for foreigners, increasing the foreign demand for these goods, thereby increasing exports and ultimately net exports.

In summary, lower prices lead to higher demand, as illustrated in our aggregate demand graph. This concept is evident when looking at the CPI index and GDP values at different price levels. It is crucial to note that the quantities discussed here represent the dollar amount of goods demanded by the entire economy, reflecting both the quantity and price axes extended to the wider economic context of GDP and overall price levels. This connection provides a comprehensive view of the economy, much like our study of market demand, but on a more extensive scale.

Alright, let's pause here and move on to the next topic.

Here’s what students ask on this topic:

What is aggregate demand in macroeconomics?

Aggregate demand (AD) in macroeconomics refers to the total demand for all goods and services in an economy at a given overall price level and in a given period. It is represented by the equation AD = C + I + G + (X - M), where C is consumption, I is investment, G is government spending, and (X - M) is net exports (exports minus imports). The AD curve is downward sloping, indicating that as price levels decrease, the quantity of real GDP demanded increases due to the wealth effect, interest rate effect, and net exports effect.

Why does the aggregate demand curve slope downward?

The aggregate demand curve slopes downward due to three main effects: the wealth effect, the interest rate effect, and the net exports effect. The wealth effect suggests that lower price levels increase the real value of money, allowing consumers to purchase more goods and services. The interest rate effect indicates that lower price levels lead to lower interest rates, which stimulate investment spending. Lastly, the net exports effect shows that lower domestic price levels make a country's goods cheaper for foreign buyers, increasing exports. Together, these effects increase the quantity of real GDP demanded as price levels fall.

How do changes in price levels affect aggregate demand?

Changes in price levels affect aggregate demand through the wealth effect, interest rate effect, and net exports effect. When price levels decrease, the real value of money increases, allowing consumers to buy more goods and services (wealth effect). Lower price levels also lead to lower interest rates, encouraging more investment by firms (interest rate effect). Additionally, lower domestic prices make goods cheaper for foreign buyers, boosting exports (net exports effect). Conversely, higher price levels reduce the real value of money, increase interest rates, and make domestic goods more expensive for foreign buyers, decreasing aggregate demand.

What components make up aggregate demand?

Aggregate demand is composed of four main components: consumption (C), investment (I), government spending (G), and net exports (X - M). Consumption refers to household spending on goods and services. Investment includes business expenditures on capital goods like machinery and buildings. Government spending encompasses all government expenditures on goods and services. Net exports represent the difference between a country's exports and imports. The aggregate demand equation is AD = C + I + G + (X - M), reflecting the total demand for goods and services in an economy.

What is the wealth effect in the context of aggregate demand?

The wealth effect in the context of aggregate demand refers to the change in consumption resulting from a change in the real value of money due to price level changes. When price levels decrease, the real value of money increases, meaning consumers can buy more goods and services with the same amount of money. This increase in purchasing power leads to higher consumption, which in turn increases aggregate demand. Conversely, when price levels rise, the real value of money decreases, reducing consumers' purchasing power and leading to lower consumption and aggregate demand.