Lesson summary: aggregate demand (article) | Khan Academy (2024)

Aggregate demand is a graphical model that illustrates the relationship between the price level and all of the spending that households, businesses, the government, and other countries are willing to do at each price level.

If that sounds familiar, it should! The components of aggregate demand are identical to the components that are used to calculate real GDP using the expenditures approach:

• Consumption
• Investments
• Government spending
• Net exports.

The AD curve is one part of a three-part model that describes something called “National Income Determination.” That’s quite a mouthful, but remember that national income is real GDP. In other words, part of what determines national income is all of the spending done by households (consumption), firms (investment), government (government spending), and the rest of the world (net exports). AD shows the amount of that spending at various price levels.

Along the AD curve, real GDP increases and the price level decreases. In other words, AD slopes down. Changes in the price level will cause a movement along the AD curve.

There are three main reasons why we would expect real GDP to increase in response to a decrease in the price level, and vice versa: the wealth effectinterest rate effectthe exchange rate effect

Any change to a component of Aggregate Demand (AD) that is not in response to a change in the price level will cause AD to shift. An increase in AD would be a shift to the right. A decrease in AD would be a shift to the left.

For example, if everyone gets an unexpected bonus added to their allowance on the same day, then consumption would increase and AD would shift right. Or, imagine if a central bank increases an important interest rate. In response, firms buy less capital and other interest-sensitive spending, which decreases Investments. As a result, AD will shift to the left. If American made cars were suddenly popular in China, then exports from the U.S. would increase and AD in the U.S. would increase, shifting to the right.

The intuition behind the real wealth effect is that when the price level decreases, it takes less money to buy goods and services. The money you have is now worth more and you feel wealthier. So, in response to a decrease in the price level, real GDP will increase. More formally, this means that when households’ assets are worth more in terms of their purchasing power, they are more likely to purchase more goods and services.

The opposite happens when the price level increases. If the price of everything increases, but the number of dollars you have doesn’t, then you have to cut back on spending. Some shorthand of this chain of events can help us wrap our heads around this:

The intuition behind the interest rate effect is that when the price level decreases, you need less money in your pocket to buy stuff. The less money you need to keep on hand to buy stuff, the more money you are going to keep in a bank. Banks pay interest to try to lure people to deposit their money in banks. So, if you are going to keep more money in the bank anyway, banks don’t have to offer as much interest in order to convince you; that drives interest rates down. As a result, businesses and households spend more money on investment and “big ticket” items that are interest sensitive, like X, Y, and Z. So, once again, a decrease in the price level will increase real GDP.

On the other hand, a higher price level will drive up interest rates. Remember how a higher price level would make everyone’s dollars are worth less, and they cut back on consumption? Well, what if they didn’t want to cut back on consumption. Instead, maybe they sell off some other asset like a bond to try to get more money. The problem is, every other bondholder is also trying to sell off their bonds, so there are no buyers! Anyone who wants to issue a new bond is going to have to do something to try to attract buyers. The way to do that is to raise the interest rate that is offered. All of that excess demand for money leads to an increase in the interest rate.

Finally, the intuition behind the exchange rate effect is that a decrease in the price level in country A makes its goods cheaper to country B, so country B buys more of country A’s exports. When the price level in one country goes down, its goods are suddenly more attractive to every other country. It’s like the whole country is on sale! Since that country’s goods are suddenly cheaper, their exports go up.

Of course, as with the other explanations for the downward-sloping aggregate demand curve, the opposite will happen when the price level increases. Country A’s goods will be less attractive to Country B’s consumers and the quantity of aggregate output demanded will decrease.

One important note: in all three of these effects, the changes in the amount of AD are brought about by a change in the price level. But if wealth, interest, or exports change for some reason besides a change in the price level, this would actually represent a shift in AD, not a movement along the curve. [got it!]

The aggregate demand curve shows the inverse relationship between the price level spending on real GDP. Figure 1 shows an economy that responds to a decrease in the price level by increasing the amount of aggregate demand. The price level decreases from $120$‍ to $102$‍ and, in response, spending on output increases from $\mathrm{\$}16\text{trillion}$‍ to $\mathrm{\$}17\text{trillion}$‍.

• AD shows the relationship between the price level and real GDP, not the relationship between price level and nominal GDP.
• It might seem strange that changes in the wealth, interest rates, and exports can cause a movement along the AD curve, while also causing a shift of the entire AD curve. To tell whether it is a shift or a movement, consider what is causing the change. If the cause is a change in the price level, it is a movement along the curve. If the cause is something besides a change in the price level, the entire AD curve will shift.
• Some students have the misperception that taking shortcuts in labeling graphs is more efficient. But, this cannot be said enough: don’t take shortcuts in labeling your graphs!

• Show the impact of a change in consumer incomes on a correctly labeled graph of the aggregate demand model.

  When consumer incomes increase, AD will increase. We show this in a graph as a shift to the right of an AD curve.

  Take a moment to note all of the elements you need to correctly label this graph:

  • A vertical axis labeled “PL” for price level
  • A horizontal axis labeled real GDP
  • The initial AD curve which is downward sloping and labeled “$A{D}_1$‍” to denote that it is the initial curve
  • The new AD curve which is downward sloping and labeled “$A{D}_2$‍” to denote that it is the second curve
  • An arrow showing the direction of the change
• What is the difference between a change in real interest rates and the interest rate effect?
• List the five things that can cause aggregate demand to increase.