In this lesson summary review and remind yourself of the key terms and graphs related to aggregate demand (AD). Topics include the wealth effect, the interest rate effect, and the exchange rate effect, as well as the factors that shift AD.
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:
- Government spending
- Net exports.
|price level||some measure that captures all of the prices that exist in an economy; the CPI or the GDP deflator are two such measures of the overall price level.|
|aggregate demand||a graphical model that shows the relationship between the price level and spending on real GDP; the AD curve shows that if the price level decreases, then real GDP increases.|
|change in aggregate demand||a shift of the entire AD curve that will occur due to a change in one of the categories of AD that is not in response to a change in the price level|
|movement along AD||a change in the amount of output demanded that occurs due to a change in the price level|
|interest-sensitive consumption||spending that is part of the “C” category of real GDP that is sensitive to interest rates; for example, if you have to take out a loan to buy a big fancy car, you are more likely to do that if interest rates are low.|
|real wealth effect||what occurs when a change in the price level leads to a change in consumer spending; this happens because assets have more or less purchasing power. If the price level decreases, then money in your bank account can suddenly buy more stuff, so you feel wealthier and buy more stuff.|
|interest rate effect||what occurs when a change in the price level leads to a change in interest rates and interest sensitive spending; when the price level drops, you keep less money in your pocket and more in the bank. That drives down interest rates and leads to more investment spending and more interest-sensitive consumption.|
|exchange rate effect||(sometimes called the foreign purchases effect) when a change in the price level in one country leads to other countries purchasing more of that country’s goods. That makes net exports (and therefore real GDP) increase. If the price level in Maxistan decreases, then its goods are cheaper relative to Jacksonia, which means Maxistan’s exports increase and its real GDP increases.|
|fiscal policy||the use of taxes, government spending, or government transfers to affect real GDP|
|monetary policy||the use of the money supply to impact interest rates, which in turn affects real GDP|
The aggregate demand (AD) curve
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.
Why AD slopes down
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 effect interest rate effect the exchange rate effect
Shifts in Aggregate Demand
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.
Digging deeper: The intuition behind the wealth, interest rate, and exchange rate effects
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!]
Key Graphical Model
The aggregate demand curve
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
to and, in response, spending on output increases from to .
- 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.
- 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.
Want to join the conversation?
- Why am I doing this?(12 votes)
- It's supposed to "help you later on in life", or if you get into those really complex and complicated jobs(1 vote)
- 2. What is the difference between a change in real interest rates and the interest rate effect?
The first can be a movement along as well as a shift of the AD curve, the second is only about a movement along the AD curve.
Interest rate effect describes movement along the Aggregate Demand curve due to change in Price Level. Price level affects how much people spend and save, which affects the interest rate. Decrease in Price level leads to decrease in interest rate which in turn leads to increase in investment and consumption, which are both direct categories of GDP, so Real GDP increases (moving along the AD curve).
But change in real interest rate can also happen due to other reasons, than change in price level (e.g. monetary policy). In that case, the whole AD curve will shift left/right.(5 votes)
In the para related to real wealth effect you mentioned that as prices reduce people consume less and in the para below it in interest effect you have said that as prices drop people save more. Kindly clarify this. Also please clarify whether the marginal propensity to consume changes as prices drop or rise, which will lead to either more saving or more consumption.
PS: I am not able to see the video because of time constraints. I am only quoting the lesson summary.(5 votes)
- Can a change in minimum wage shift the aggregate demand?(3 votes)
- 3. List the five things that can cause aggregate demand to increase.
1) increase in household consumption
2) increase in business investment
3) increase in government spending
4) increase in exports
5) decrease in imports
If they are not caused by a change in the price level. Otherwise the aggregate demand doesn't change and real GDP only moves along the aggregate demand curve.(4 votes)
- what factors might cause consumers to spend more of their income on goods and services, thereby shifting the aggregate demand curve rightward?(2 votes)
- For one, having more income to spend might do this. A change in the marginal propensity to consume might do this as well. For example, let's say I have less confidence that I will retire, so I save less. Each additional dollar of income I get I now save 10% instead of 20%.(2 votes)
- What is the difference between a change in real interest rates and the interest rate effect?(2 votes)
- I think the answer might be related to how REAL interest rates account for changes in price level (like if there is inflation), whereas the interest rate effect does not necessarily adjust for that. I'm not sure though.(1 vote)
- Does the wealth effect shift the AD Curve or move along it?(1 vote)
- It might be a stupid question, but if price decrease causes GDP increase, why won't the governments just decrease all of the prices? In that case, GDP would go up:)(1 vote)
- Take another look back at the issues of price ceilings and floors, and how they either have no effect or lead to deadweight loss in an economy. In this case, capping prices would create a ceiling and lead to an inefficient market.(2 votes)