The Aggregate-Demand Curve

The aggregate-demand curve tells us the quantity of all goods and services demanded in the economy Opens in new window at any given price level.

Aggregate-demand curve is a curve that shows the quantity of goods and services that households, firms, the government, and customers abroad want to buy at each price level.

 Figure I, Aggregate-Demand Curve | Source: Aleeza Baig@SlideShare Opens in new window

As Figure I illustrates, the aggregate-demand curve slopes downward.

This means that, other things being equal, a decrease in the economy’s overall level of prices (from, say, P1 to P2) raises the quantity of goods and services demanded (from Y1 to Y2). Conversely, an increase in the price level reduces the quantity of goods and services demanded.

Why the Aggregate-Demand Curve Slopes Downward

Why does a change in the price level move the quantity of goods and services demanded in the opposite direction?

To answer this question, it is useful to recall that an economy’s GDP (which we denote as Y) is the sum of its consumption (C), investment (I), government purchases (G), and the exports (NX):

Y = C + I + G + NX.

Each of these four components contributes to the aggregate demand curve for goods and services. For now, we assume that government spending is fixed by policy.

The other three components of spending — consumption, investment, and net exports — depend on economic conditions and, in particular, on the price level. Therefore, to understand the downward slope of the aggregate-demand curve, we must examine how the price level affects the quantity of goods and services demanded for consumption, investment, and net exports.

The Price Level and Consumption: The Wealth Effect

Consider the money Opens in new window that you hold in your wallet and your bank account.

The nominal value of this money is fixed: One dollar is always worth one dollar.

Yet the real value of a dollar is not fixed. If a candy bar costs one dollar, then a dollar is worth one candy bar. If the price of a candy bar falls to 50 cents, then one dollar is worth two candy bars.

Thus, when the price level falls, the dollars you are holding rise in value, which increases your real wealth and your ability to buy goods and services.

This logic gives us the first reason the aggregate-demand curve slopes downward.

A decrease in the price level raises the real value of money and makes consumers wealthier, which in turn encourages them to spend more. The increase in consumer spending means a larger quantity of goods and services demanded. Conversely, an increase in the price level reduces the real value of money and makes consumers poorer, which in turn reduces consumer spending and the quantity of goods and services demanded.

The Price Level and Investment: The Interest-Rate Effect

The price level is one determinant of the quantity of money demanded. When the price level is lower, households do not need to hold as much money to buy the goods and services they want.

Therefore, when the price level falls, households try to reduce their holdings of money by lending some of it out.
• For instance, a household might use its excess money to buy interest-bearing bonds.
• Or it might deposit its excess money in an interest-bearing savings account, and the bank would use these funds to make more loans.

In either case, as households try to convert some of their money into interest-bearing assets, they drive down interest rates.

Interest rates, in turn, affect spending on goods and services.

Because a lower interest rate makes borrowing less expensive, it encourages firms to borrow more to invest in new plants and equipment, and it encourages households to borrow more to invest in new housing. (A lower interest rate might also stimulate consumer spending, especially spending on large durable purchases such as cars, which are often bought on credit.) Thus, a lower interest rate increases the quantity of goods and services demanded.

This logic gives us the second reason the aggregate-demand curve slopes downward.

A lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded. Conversely, a higher price level raises the interest rate, discourages investment spending, and decreases the quantity of goods and services demanded.

The Price Level and Net Exports: The Exchange-Rate Effect

As we have just discussed, a lower price level in the United States lowers the U.S. interest rate. In response to the lower interest rate, some U.S. investors will seek higher returns by investing abroad.

• For instance, as the interest rate on U.S. government bonds falls, a mutual fund might sell U.S. government bonds to buy German government bonds.
• As the mutual fund tries to convert its dollars into euros to buy the German bonds, it increases the supply of dollars in the market for foreign currency exchange.
The increase supply of dollars to be turned into euros causes the dollar to depreciate relative to the euro.

This leads to a change in the real exchange rate — the relative price of domestic and foreign goods. Because each dollar buys fewer units of foreign currencies, foreign goods become more expensive relative to domestic goods.

The change in relative prices affects spending, both at home and abroad.

Because foreign goods are now more expensive, Americans buy less from other countries, causing U.S. imports of goods and services to decrease.

At the same time, because U.S. goods are now cheaper, foreigners buy more from the United States, so U.S. exports increase. Net exports equal exports minus imports, so both of these changes cause U.S. net exports to increase.

Thus, the fall in the real exchange value of the dollar leads to an increase in the quantity of goods and services demanded.

This logic yields the third reason the aggregate-demand curve slopes downward.

When a fall in the U.S. price level causes U.S. interest rates to fall, the real value of the dollar declines in foreign exchange markets. This depreciation stimulates U.S. net exports and thereby increases the quantity of goods and services demanded. Conversely, when the U.S. price level raises and causes U.S. interest rates to rise, the real value of the dollar increases, and this appreciation reduces U.S. net exports and the quantity of goods and services demanded.

Summing Up

There are three distinct but related reasons a fall in the price level increases the quantity of goods and services demanded:

1. Consumers are wealthier, which stimulates the demand for consumption goods.
2. Interest rates fall, which stimulates the demand for investment goods.
3. The currency depreciates, which stimulates the demand for net exports.
The same three effects work in reverse:

When the price level rises, decreased wealth depresses consumer spending, higher interest rates depress investment spending, and a currency appreciation depresses net exports.

Here is a thought experiment to hone your intuition about these effects.

Imagine that one day you wake up and notice that, for some mysterious reason, the prices of all goods and services have fallen by half, so the dollars you are holding are worth twice as much.

In real terms, you now have twice as much money as you had when you went to bed the night before.

What would you do with the extra money?
• You could spend it at your favorite restaurant, increasing consumer spending.
• You could lend it out (by buying a bond or depositing it in your bank), reducing interest rates and increasing investment spending.
• Or you could invest it overseas (by buying shares in an international mutual fund), reducing the real exchange value of the dollar and increasing net exports.
Whichever of these three responses you choose, the fall in the price level leads to an increase in the quantity of goods and services demanded. This is what the downward slope of the aggregate-demand curve represents.

It is important to keep in mind that the aggregate-demand curve (like all demand curves) is drawn holding “other things equal.”

In particular, our three explanations of the downward-sloping aggregate-demand curve assume that the money supply is fixed.

That is, we have been considering how a change in the price level affects the demand for goods and services, holding the amount of money in the economy constant.

As we will see, a change in the quantity of money shifts the aggregate-demand curve Opens in new window. At this point, just keep in mind that the aggregate-demand curve is drawn for a given quantity of the money supply.