Source: Image of AD/AS graph created by Kate Eskra, Image of AD curve created by Kate Eskra
Hi, Welcome to Macroeconomics. This is Kate. This tutorial is on aggregate demand. As always, my key terms are in red, and my examples are in green.
In this tutorial we'll talk about what aggregate demand is, and you'll see what it looks like on a graph. And we'll discuss the three reasons why aggregate demand slopes downward. And it's because of the wealth effect, the interest rate effect, fact and the exchange rate effect.
So here's the aggregate supply and aggregate demand model. In this tutorial we'll only be focusing on this green line, which is aggregate demand, but I thought it would help for you to see how the whole model will eventually come together.
Notice how the x-axis on this graph represents real GDP. So in microeconomics the graph is very similar, with the x-axis being quantity, but here this is the overall quantity in an economy. And I'll define for you real GDP in a second.
The y-axis is price in microeconomics. Here it's the overall price level. So it's the price of everything in the economy. And this is the most common graph that shows overall, or macroeconomic activity. So we use it lot in macroeconomics.
So that x-axis, that real GDP, is one of your key terms. And real GDP is really gross domestic product, is the sum of the final value of goods and services produced over a specific time interval, and within a country's borders. And what we do is we calculate this across time periods using a constant price level. And that's where this real part of it comes in. When we adjust for price level changes, we're talking about real GDP. And we use it to compare, from time period to time period, whether an economy is more productive, or less productive.
The price level on that y-axis is an aggregate index value that provides an indication of the increase in prices from one period to another. And so if there's movement up in that graph, then we could be able to see that there is some inflation from one time period to the next. If there's movement down, then that would be an indication of deflation, or prices falling.
OK, so this tutorial, though, is on aggregate demand. So this is the total amount of goods and services demanded in an economy, at a specific point in time, and at a prevailing price level. So in microeconomics it was just more specific-- the demand for shoes, the demand for the houses. This is the demand for everything, and this is what it looks like.
So notice that it is, as in microeconomics, a downward sloping curve, which shows an inverse relationship here between the overall price level and real GDP, as I just defined for you. So what this tells us is that people will want to purchase more as the overall price level falls. So as prices go down, people want to buy more. As prices go up, people want to buy less. We're used to that. That's easy.
But we need to keep in mind that aggregate demand-- when we say people want to purchase more, we mean some different groups of people. C is consumers, I are businesses, or firms, G are governments, and then this X minus M is net foreign purchases of US goods. So X would be exports, and m would be imports. So when we subtract the two, we get our net foreign purchases of our goods.
So why does it slope down from left to right? Why do people want to purchase more as the overall price level falls? Well, there are three reasons. And the first reason is the wealth effect.
So the wealth effect says that as prices fall, we feel like we're wealthier. We feel like we have more money, because things are cheaper. And because our money can go farther, people tend to buy more. Makes sense, right? So that's the C component of aggregate demand, consumer purchases. And that's really impacted here by the wealth effect as prices fall. So the wealth effect is defined as the perception that our wealth has increased as prices fall, resulting in an increase in net C component of aggregate demand, or consumption.
Then we have the interest rate effect. So this gets a little bit more technical. As prices in an economy fall, what that does is that increases the amount of money circulating in our economy. And when there's a lot more money circulating in our economy, that's going to drive down interest rates. So whereas with the wealth effect, if things are cheaper, people might buy more of almost everything-- they might buy more shoes, and clothes, and then things like that.
With the interest rate effect, we're looking at things that are interest rate sensitive-- so more durable goods, things that require loans. You're not going to go grocery shopping more because interest rates are down, but people might start to purchase more cars, houses, appliances, furniture, those kinds of things. So C, again, will be impacted, but it's for things that require loans. Firms or businesses will also take advantage of lower rates during these times, and tend to make investments in their company. So really when we look at what components are impacted with the interest rate effect, it's C and I.
So the interest rate effect here defined for you says that as interest rates fall, consumption increases due to the decrease in the cost of borrowing. And as a result, purchases and business investment-- so C and I-- will both increase.
Finally we have the exchange rate effect. And this will impact this last part of aggregate demand. So as prices in our country go down, our goods become relatively cheaper to foreigners, as our exchange rate falls against theirs. And so foreigners will tend to buy more from us. That would increase this X component, or our exports, and we also tend to buy less from other countries, now that our exchange rate won't get us to far. So our imports have the potential here to fall.
So for example, when our things get cheaper to foreigners, we might see more people from other countries vacationing here, and we may we go vacation less in other countries, as well as it will impact our actual physical purchases of items-- goods-- in other countries, as well. So here, again, this is impacting our exports and imports.
So the exchange rate effect is defined as exchange rate movements, and how they impact demand. Domestic currency depreciation, meaning that our currency is weaker, relative to other countries-- that increases the cost of imports. So there's that potential decrease in imports, or M. That lower domestic exchange rate, though, increases what foreigners would like to demand from us, and so that increases the X component of aggregate demand.
So in this tutorial we looked at what aggregate demand is, and what it looks like. You saw that it's a downward sloping curve from left to right, with price level on the y-axis, and real GDP on the x-axis. And the three reasons why people want to buy more as the price level falls are because of the wealth, interest rate, and exchange rate effects. Thanks so much for listening. Have a great day.
The total amount of goods and services demanded in an economy at a specific point in time and at a prevailing price level.
Perception that wealth has increased, resulting in an increase in consumption, C.
Interest Rate Effect
As interest rates fall, consumption increases due to the decrease in the cost of borrowing; as a result, purchases and business investment (Consumption, C, and investment, I, respectively) both increase.
Exchange Rate Effect
Exchange rate movements impact demand; domestic currency depreciation increases the cost of imports, resulting in a potential decrease in imports, M; the lower domestic exchange rate increases foreign demand for domestic goods, increasing exports, X.
An aggregate index value that provides an indication of the increase in prices from one period to another; used to evaluate inflation across periods.
Real Gross Domestic Product: Gross Domestic Product (the sum of the final value of goods and services produced over a specific time interval and within a country’s national borders.) calculated across time periods using a constant price level.