Aggregate Demand and Aggregate Supply

Aggregate Demand

What Is Aggregate Demand?

Aggregate demand is the total quantity of goods and services that households, firms, the government, and foreign buyers demand at each price level at a given time.
Aggregate demand (AD) is the total demand for final goods and services in an economy at a given price level at a specific time. Gross domestic product (GDP) is the measurement of a country's total economic output. Graphically, the aggregate demand curve is plotted with real output (real GDP) on the horizontal axis and the price level (GDP deflator or Consumer Price Index) on the vertical axis. AD is calculated in a similar way as GDP:
AD=C+I+G+(XM)AD=\;C\;+\;I\;+\;G\;+\;(X-M)
Similar to the calculation of GDP, consumption (C) is equivalent to all consumer spending, which is total individual and household purchases of consumer goods and services. Investment (I) is the money corporations spend to grow their businesses, such as building a factory or investing in software that can make their business run faster. Government spending (G) includes infrastructure investments, such as a new freeway. X represents the total exports of the country, and M represents the imports. An export is a good or service sold in other countries; an import is a good or service produced abroad and bought domestically. The important element to consider about the downward slope of the AD curve is that it is not just reflecting on the price of one product in an economy; rather, it is an aggregate of all products. It reflects changes in total demand for goods in relationship to changes in the price level in the economy.

The aggregate demand equation groups so many different types of spending (consumer, government, business, imports, and exports) that it is difficult to combine all of these elements to predict the exact cause and effect of economic growth or decline.

John Maynard Keynes, an economist who developed the Keynesian model of macroeconomics, challenged traditional economic thought about aggregate demand and aggregate supply in his work The General Theory of Employment, Interest, and Money. Keynes argued that unemployment was a by-product of insufficient aggregate demand. He also argued that a decrease in aggregate demand created a string of events that could be prevented if government worked to increase spending.

Why the Aggregate Demand Curve Slopes Down

The aggregate demand curve slopes downward for three reasons: the wealth effect, the interest-rate effect, and the exchange-rate effect.
Graphically, the aggregate demand (AD) curve depicts an inverse or negative relationship between the overall price level and aggregate demand. It is important to remember that the downward slope of the AD curve shows the relationship between overall price levels in the economy and the total amount of all goods and services demanded in the economy. The reason for the downward slope of the AD curve should not be confused with the reasons for the downward slope of the demand for an individual product or service. The demand curve for an individual product or service slopes downward because, when the individual price of the product or service falls, consumers can afford to buy more with their fixed income. Additionally, as the price for the good or service falls, consumers can substitute more of the now-cheaper product or service for other, more expensive goods.

The slope of the AD curve is downward sloping for three main reasons: the wealth effect, the interest-rate effect, and the exchange-rate effect.

The first reason for the downward slope of the AD curve is called the wealth effect, or the real money balances effect, in which the real wealth of consumers changes because of a change in the price level. For example, suppose that a price level decreases. Before the price level changed, a person could buy four video games for $100. After the price level decreased, that same $100 could buy five video games. The nominal amount, $100, did not change, but the purchasing power of a unit of money did. When purchasing power increases, people feel wealthier. This feeling encourages an increase in consumer spending, which in turn increases aggregate demand. The inverse of this is also true. When the price level increases, people feel less wealthy and choose to spend less, thereby decreasing aggregate demand. This inverse relationship between price level and aggregate demand helps explain the reason for the downward slope of the AD curve. When prices increase, the real value of the money an average consumer holds falls, so spending decreases. When prices decrease, the real value of money an average consumer holds rises, increasing spending because products become relatively cheaper and people are able to buy more.
The graph of aggregate demand (the total demand for goods and services at a particular price level) slopes downward, showing the inverse or negative relationship between price level and output or GDP, i.e., as price increases, demand decreases.
The second reason is the interest-rate effect, which shows that a lower price level reduces the interest rate, which stimulates spending on investment. The interest rate is the cost of borrowing money, expressed as a percentage of the amount borrowed; or, equivalently, the return on savings. A high price level means people need more money to make purchases. This increases the demand for money. A low price level means people need less money to make purchases. This decreases the demand for money and increases savings because people may have money left over after making purchases. This increases the amount of money in the bank, which banks then use to make loans. An increase in the amount of loanable funds decreases the price of loans (interest rates). When the interest rate is low, more businesses and individuals take out loans to make investments, which are a component of AD. When investments increase, so does AD. This relationship between price level and AD also helps explain the downward slope of the AD curve. The third reason is the exchange-rate effect, or the international effect. As price levels fall, domestic consumers need less money to make purchases, so saving in the domestic economy increases. This increase in savings increases loanable funds, which results in lower domestic interest rates relative to foreign rates. The higher rate of return in foreign interest-bearing assets overseas attracts investment from the domestic economy. In order to invest in these foreign assets, domestic investors must first convert their currency to the foreign currency. They demand more foreign currency and, as a result, supply more of the domestic currency. This causes the value of the foreign currency to appreciate (become stronger) relative to the domestic currency. This appreciation in the foreign currency effectively lowers the price foreigners pay for goods and services in the domestic economy. Exports from the domestic country increase, which increases net exports ( XMX\;-\;M ). As net exports increase, AD increases. The opposite effect takes place for an increase in domestic price levels: domestic savings decline and domestic interest rates rise. As a result, domestic consumers demand less foreign currency and supply less domestic currency. The domestic currency appreciates relative to foreign currency, which effectively causes foreigners to have to pay more for goods and services in the domestic economy. Exports from the domestic country fall, which causes AD to fall.

In very simple terms, a lower price level causes domestic economy exports to become cheaper, which stimulates foreign spending. Economies abroad are more likely to purchase goods and services from the domestic economy when they are cheaper. Additionally, domestic consumers are likely to purchase fewer imports. This causes net exports to rise, which increases AD. However, when price levels rise, exports of domestic goods and services decrease as they are now relatively more expensive and domestic consumers import more relatively cheaper foreign goods and services. This results in a decrease in net exports and a decrease in aggregate demand in the domestic economy.

Shifts in the Aggregate Demand Curve

Shifts in the aggregate demand curve are caused by changes in consumption expenditures, investment expenditures, government expenditures, and imports and exports.
Aggregate demand (AD) refers to the amount of total spending on domestic goods and services in an economy. An aggregate demand curve shows the total spending on domestic goods and services at each price level in a given time period. The components of AD are as follows:
  • Consumption (C)
  • Investment (I)
  • Government spending (G)
  • Net exports
(exportsimports;XM)(\mathrm{exports}\;-\;\mathrm{imports};\;\mathrm X\;-\;\mathrm M) Shifts in the AD curve can be caused by changes in any of the components of AD. Changes in the price level will not shift the AD curve. Since GDP and AD are linked, when the aggregate demand decreases, GDP also decreases, and when aggregate demand increases, GDP increases.

Four factors can thus cause the AD curve to shift, and the first is changes in consumption expenditure (C). When consumption expenditure increases, the AD curve will shift to the right. When consumption expenditure decreases, the AD curve will shift to the left. For instance, changes in government tax policies can impact consumption expenditure. When individuals are taxed at higher rates, they often spend less, which causes the AD curve to shift to the left. Consumers’ after-tax income would decrease, and they would spend less on goods and services. A decrease in personal income taxes would increase consumption expenditure, which shifts the AD curve to the right. Consumers’ after-tax income would increase, and they would spend a portion of this increase on goods and services. Changes in consumer attitudes about consumption can also cause the AD to shift. When more Americans decide to focus on saving (which can occur in a recession or a time of economic instability), the AD curve shifts to the left.

The second factor that creates a shift in the AD curve is investment expenditure (I). When investment expenditure increases, the AD curve will shift to the right. When investment expenditure decreases, the AD curve will shift to the left. As firms become more optimistic about economic growth, they increase their investment spending, shifting the AD curve to the right, increasing aggregate expenditure and therefore GDP. Corporate taxation policies that affect investment can also shift the AD curve. If firms are given an investment tax credit (or a rebate by the government), this would increase aggregate expenditure and shift the AD curve to the right. However, if corporate taxes are increased or firms become more pessimistic about the economy, aggregate expenditure would decrease and the AD curve could shift to the left.

The third factor that can shift the AD curve is changes in government expenditure (G), which is spending by the government. When government expenditure increases, the AD curve will shift to the right. When government expenditure decreases, the AD curve will shift to the left. The most direct way policymakers can affect the AD curve is through changes in direct spending on goods and services. Additionally, changes in government regulations and other policies, direct government investments, and legislation passed to provide an economic stimulus will shift the AD curve. For example, Congress may pass legislation setting aside funds for bridge construction. The government hires contractors who build bridges, spending money on parts and labor. In this case, aggregate expenditure increases and the AD shifts to the right.

The last factor that can cause a shift in the AD curve is net exports ( XMX\;-\;M ). For example, net exports can change when foreign incomes rise or fall. If foreign incomes rise, consumers in foreign countries will increase their consumption expenditure on all goods and services. They will buy more of other countries’ goods and services as well as more of their own. Exports to the foreign country will rise, which increases net exports. A decrease in foreign incomes would have the opposite effect. Exports to the foreign country with declining incomes would decrease causing a decrease in net exports and AD in the exporting country. Changes in exchange rates will also cause the AD curve to shift. For example, in the United States, a rise in the value of the dollar relative to other foreign currencies will cause imports to the United States to rise and exports from the United States to fall. (Foreign consumers of the United States' goods and services perceive that these goods and services are more expensive relative to foreign goods.)