What is Aggregate Demand

  • The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, business, the government and the rest of the world

  • Aggregate output and real GDP can be used interchangeably

  • All things equal, a movement down the AD curve leads to a lower aggregate price level and higher aggregate output, and vice versa

  • Recall the basic equation of national income accounting

    • Y = C + I + G + NX

    Price Level AD Real GDP

Why is the AD Downward Sloping?

  • Demand Curve vs. Aggregate Demand Curve

    • If the demand for one product is downward sloping, wouldn’t the aggregate demand also do the same?

    • The demand curve for an individual good assumes that you hold price of other goods constant

    • For the aggregate demand, there is a simultaneous change in the price of all final goods and services!

    • If the price of gas goes up, and people buy more econ textbooks, it doesn't necessarily change anything at all.

    • So then, why does a rise in the aggregate price level lead to a fell in the quantity of all domestically produced final goods and services produces?

  • Wealth Effect

    • change in consumer spending caused by the altered purchasing power of consumer's assets

    • An increase in the aggregate price level means people are relatively poorer, and vice versa

    • Thus, consumer spending or C, changes and you move up and down the AD curve

  • Interest Rate Effect

    • change in investment and consumer spending caused by interest rates that result from changes in demand for money

    • With a higher aggregate price level, causes an increase in money holdings which reduces funds available for borrowing

    • Interest rate increase and consumer spending, C, and investment spending, I decreases

Shift in the Aggregate Demand Curve

Level Decrease In AD Increase In AD ADZ Real GDP

  • Changes in Expectations

    • Consumers base spending on future income

    • If the Conference Board, or Michigan Consumer Sentiment Index reports an increase in consumer confidence, AD has increased

  • Changes in Wealth

    • People with more wealth will tend to spend more

    • If the stock market crashes or real estate values plummet, the AD shifts to the left

  • Size of the Existing Stock of Physical Capital

    • If the inventory of housing is high, the AD will shift left

    • If inventory is low, then AD will shift to the right

  • Fiscal Policy (use of taxes and government spending)

    • Expansionary fiscal policy

      • Increase in Government spending or decrease in taxes will shift AD to the right

    • Contractionary fiscal policy

      • Decrease in Government spending or increase in taxes will shift AD to the left

  • Monetary Policy (central bank's or Fed's use of changes in quantity of money or interest rates)

    • Expansionary monetary policy

      • If the Fed increase the money supply (lowered interest rates), then AD increases

    • Contractionary monetary policy

      • If the Fed decrease the money supply (higher interest rates), then AD decreases

Factors That Shift the Aggregate Demand Curve Changes in expectations If consumers and firms become more optimistic, . If consumers and firms become more pessimistic, Changes in wealth If the real value of household assets rises, . If the real value of household assets falls, . Size of the existing stock of physical capital If the existing stock of physical capital is relatively small, . If the existing stock of physical capital is relatively large, Fiscal policy If the government increases spending or cuts taxes, . If the government reduces spending or raises taxes, . Monetary policy If the central bank increases the quantity of money, . If the central bank reduces the quantity of money, .. aggregate demand increases. aggregate demand decreases. aggregate demand increases. aggregate demand decreases. aggregate demand increases. ... aggregate demand decreases. aggregate demand increases. aggregate demand decreases. aggregate demand increases. ... aggregate demand decreases.

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