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Aggregate demand

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We've learned about demand for a good or service, but aggregate demand is different: its the demand for everything bought in an economy. In this video, we discuss how aggregate demand (AD) is different from demand and why aggregate demand is downward sloping.  Created by Sal Khan.

Video transcript

In this and the next few videos we're going to be studying something called "aggregate supply" and "aggregate demand." Actually, we're going to start with aggregate demand and then start talking about aggregate supply. We're going to think about aggregate demand and aggregate, I'll rewrite the word, aggregate supply. What I really want to emphasize in this video is in a lot of ways, it's going to look similar to traditional supply and demand, but I want to emphasize that there's a very big difference between aggregate demand and traditional demand in a microeconomic context. Aggregate supply in a macroeconomic context and just regular supply in a microeconomic context. To think about that, let's go to the micro version. These are macroeconomics so we're looking at economy as a whole. These are macro ideas. To make that comparison, let's revisit the micro-, the microeconomics ideas of supply and demand. To do that, we can focus on a particular market. Maybe it's the market for candy bars, so this is the market for candy bars. We've seen this many, many, many times, this is most of what we were doing when we were studying microeconomics. On the vertical axis, we would plot the price per unit from the candy bar and the horizontal axis you would have the quantity bought or sold in the given amount of time. We saw that the demand curve tended to be downward sloping, it would look something like that. There was multiple ways to interpret this. One way to interpret this at a high price, people would say, "Why should I buy this candy bar? I could buy other things with that money that would make me just as happy or happier." So they would purchase a low quantity of it. At a low price, this is a low price right over here, people say, "This is a pretty good deal. I can get candy bars, they're so cheap, I can buy a bunch of them. Instead of buying other things, instead of buying lollipops and ice cream, I'll buy candy bars," then they'll buy a high quantity of it. So that's one way to interpret it. The other way to interpret it was as essentially as a marginal benefit curve. That very first few units of candy bars to get produced, there's someone there who just loves candy bars so much there's a high willingness to pay for it. There's a high benefit for those first few units. As you have more and more units, the incremental benefit to the market gets less and less. You can view as they are people who still like candy bars, but not as much as the people who bought those first few units. That is why you have a downward sloping curve. When we think about aggregate demand, it's going to look very similar, but the idea is a good bit different. I'll do it in a different color to show that it's different. Now we're in the macro version. We're talking about aggregate demand. Aggregate demand. The first thing to realize is we're talking about aggregate demand. We're going to be thinking about the economy as a whole. We're not just thinking about the market for just one good or service. In aggregate demand, what we do is we plot on the horizontal axis, not quantity, not just the quantity bought or sold of one good or service in an amount of time, we plot the actual production of the economy in a given period of time. We've already studied that. The actual production of the economy in a given period of time is real GDP. We plot, on this axis, real GDP, so it's really how much are we producing? I guess there is an analogy to quantity, it's kind of the quantity of the productivity of the economy. In this axis right over here, we plot price level. This is prices. This isn't prices for one good or service, this isn't just a price for candy bars, this is the general level of prices in the economy. Maybe you're saying it's a weighted average or however you want to measure it, some way of measuring the level of prices and economy. What we will see is this is a downward sloping curve. It does look like this. It will look something like this or we can assume, we actually don't know whether it definitely looks like that, but economists will tell you it looks like that based on certain theories. They like it this way because it starts to explain, based on their models, and you can kind of separate out the emotional aspects of economics, it is one way of potentially explaining economic cycles, although if you know from the last video I'm actually a stronger believer in the emotional aspects of it. But it will be downward sloping. It will be downward sloping like this. Once again, this is one product, goods or service right over here. This is the economy as a whole. This is just a general level of prices. This is the actual productivity of the economy. This is saying, and it's a little unintuitive at first, that if prices are high, it's seldom this extreme, it's not like the GDP would go to zero, but we'll just assume it's simplified like this ... Maybe I'll draw it with something like this ... Maybe I'll have it something like, maybe draw it something like that so I don't have to make the extreme statement that if prices are at some level, that there will be no GDP. Generally saying if prices are high, GDP will contract and remember, ceteris paribus, all other things equal, if prices are low, GDP will expand. It's happening for completely different reasons than this downward sloping. This downward sloping is essentially a substitution effect. When prices are high, people say, "I don't need to buy candy bars. I can go buy ice cream or Slurpees or Slushees or something else that makes me happy," or and when prices are low, they say, "Let me substitute candy bars for other things because I'm getting a good deal on candy bars." Over here that is not what is happening. What's happening here, and there's a couple of theories why economists will justify a downward sloping aggregate demand curve, let me make this clear, this is aggregate demand. This is essentially saying how much productivity there will be in the economy as a function of price levels in the economy. This is aggregate demand ... And this is just demand right over here. There's three major theories why economists believe that there is a downward sloping aggregate demand curve. The first is called the "wealth effect." Let me write these down. The first is called the "wealth effect." The wealth effect is just saying, and once again, it's a little nonintuitive, because in my mind when I start saying prices have gone down, I start saying, "Prices have gone down, wages have gone down, maybe profits have gone down, and then people will get less optimistic, the economy will shrink." That's not what we're saying in this chart right over here. Remember, ceteris paribus ... All other things equal. We're assuming over here only, so if we take this scenario right over here, we're assuming only prices have gone down. Everything else in the economy is equal. Employment has not changed. Profits have not changed. People's optimism has not changed. The only thing that changes is people wake up one day and everything in the economy is half the price it was before. People have the same savings. They have the same amount of money in their wallet. If that happens, all things equal, now they say, "With the same amount of money that I have in my wallet, I can now buy more. I feel wealthier." That's the wealth effect. They will say, "I will go and demand more goods and services because with what I have in my pocket, I can go buy more things." Likewise, if for whatever reason people woke up the next morning ... Remember, all other things equal, if the price of everything were to double, they say, "Oh my God! I can't buy anything anymore. Everything's too expensive. I have to buy less of it. I'm going to demand fewer goods and service." The wealth effect is one theory that would explain, all other things equal, why you would have a downward sloping aggregate demand curve. The other one is related to interest rates. I would call it savings and interest rate effect. Interest rate effect. You can imagine, if before this bar represented the total amount of money someone had in their pockets, and this is how much they needed to spend on goods and services in order to have a nice, happy, productive life, this is originally what they were going to save, now all of a sudden, now if all of a sudden if things get a lot cheaper, they don't have to spend this much on goods and services. They could spend less on goods and services. Maybe if things got a lot cheaper, they could spend less on goods and services. Now they could spend maybe this amount on goods and services, and they could save much more. Right over here ... Remember, all other things equal, if everyone woke up tomorrow and things were just half priced, people would be able to spend less on the things they need, and they would be able to save a lot more money. We've seen before, savings, when people save money, it just goes into the financial system. You save it, you put it into the bank, and it just gets lent out to other people. So when you have increase in savings, all other things equal, when prices goes down, all other things equal, then savings go up which means that the supply of money to be lent, supply of lenders or money to be lent, money lending goes up. We saw that in a previous video. If you increase the supply of money that can be lent, the price of borrowing the money will go down. Another way to think about it, interest rates. Interest rates will go down. When interest rates go down, it becomes cheaper, you have to spend less interest to borrow money and make investments. Borrow money, build a house. Borrow money, build a factory. Borrow money, do whatever ... buy inventory. Interest rates go down, that stimulates investment, that stimulates investment, which once again, would cause the economy to expand. You would have more goods and services being produced. Likewise, if you went the other way, if prices went up, this is a situation where prices went down. if prices went up, now all of a sudden, people have to spend more of their money. More of their money on the things that they maybe think that they need to survive and be happy. There will be less savings. If there's less savings, there's less money to be lent. There will be higher interest rates and there will be less investment, so the economy will contract. So real GDP ... And remember, when I say GDP here, maybe I'll call it real GDP, real GDP would go down. This is real GDP would go up. The third theory of why ... or the third justification because economists like to have this downward sloping curve so that they can justify, and we'll see how aggregate supply and demand can cause business cycles, the third effect is essentially, I'll call it a foreign exchange effect. A foreign exchange effect. Foreign exchange. Based on the line of reasoning, so let's say a situation once again where prices went down, based on their line of reasoning and justification, we said if prices go down, then interest rates go down because there's more money to be lent in that economy in that currency. If interest rates go down, investors might say, "I only get low interest in my country. Why don't I convert my money into other currencies where I can get higher interest rates?" So if interest rates go down, people convert out of the currency. Convert out of the currency. So maybe before, if we're talking about America and maybe the interest rates are really low in the US and interest rates are higher in the UK, maybe because prices didn't go down there as much, people say, "I'm going to convert my money from dollars to pound sterling." When they do that, they will essentially, because once again, if people are converting from ... I've gone in-depth on some of the videos on foreign exchange, if people are converting from dollars to pounds, that means that there's a larger supply of dollars and more demand for pounds. The price of the dollar relative to the pound will go down. Essentially, the dollar will weaken. The dollar will weaken relative to other currencies. If the dollar weakens relative to the other currency, this is a little confusing, I go into more depth into this when I talk about currency exchange, if the dollar weakens relative to other currencies, then American goods and services are going to appear to be cheaper to people in England. For example, if I offer to make a car in America for $10,000, maybe $10,000 before all of this happened, translates into 5,000 pounds, but now the dollar has weakened. Now $10,000 is going to translate into 4,000 pounds. Foreign consumers will say, "Wow, American cars just got cheaper when we view it in our own currency." More and more of them are going to want to buy American things so America will export more. Once again, if there's more demand for American goods and services, the GDP will expand. This is related to low interest rates driving people to take currency out or exchange out of the currency we're talking about, which will make that currency cheaper, which will make its goods and services cheaper to the rest of the world, which it will essentially once again, make net exports increase. You really could just cut to the chase and say if the price level all of a sudden in US dollars just got cheaper, people say there's deals to be had in the US, and once again, net exports would increase. Once again, when you have low price level, you could have GDP expanding. Obviously if the prices were to increase, the opposite dynamic might occur.