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Aggregate Demand/Aggregate Supply Model
Aggregate Demand
Movement Along the Aggregate Demand Curve
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We're building a model of the macroeconomy as we seek to explain the business cycle and we've begun with the
relationship between the aggregate price level and the real gross domestic product. You recall that the equilibrium
equation in macroeconomics is that income equals spending. That is, everything that is produced in the economy has
got to be purchased by someone in equilibrium. The real gross domestic product in equilibrium is the sum of
spending by all of the agents who buy things, that is, consumer spending, business spending, the spending of
government, and the spending by foreigners, that, is our net exports.
What we're going to do now is look at the aggregate demand curve, a curve that we drew to explain the relationship
between the aggregate price level and the real gross domestic product and understand the story behind it. This
aggregate demand curve is drawn to show that when the aggregate price level rises, the equilibrium real gross
domestic product shrinks. As the price level rises, consumers, businesses, foreigners, and the government buy less
stuff. A movement along the aggregate demand curve means a reduction in real gross domestic product as the
aggregate price level rises. What is the story behind this curve? Why is it that rising price levels lead to shrinking real
gross domestic product?
Let's look now at the three stories behind this particular curve to answer the question, "Why does the aggregate
demand curve slop downwards?" The first story concerns consumer spending. How does a rise in price level
influence consumer spending? Think about it, when price levels are rising, that means the prices of all goods and
services are going up together along with your paycheck. There are some aspects of your wealth that are fixed in
nominal terms. Your savings account for instance, your savings balance does not rise along with inflation, it stays
fixed, and therefore your real wealth actually shrinks. A given amount of money to positive in the bank will buy less
after all prices have gone up. The shrinking real wealth causes households then to feel poorer and when they feel
poorer they reduce their consumer spending.
Now if consumers are buying last stuff, businesses don't want to make as much stuff. Otherwise, they will be
stranded with a lot of excess inventory. A reduction in consumer spending leads to a reduction in factory output and
that means a shrinking real gross domestic product. So the first channel through which rising prices lead to a
shrinking real gross domestic product is through the channel of real wealth and its effect on consumer spending.
The second way in which rising price levels lead to shrinking real gross domestic product works through business
spending. Investment spending is going to decrease whenever the price level rises. The story here is a little bit
longer and involves a few more steps. When the price level goes up, everybody needs more cash and more money
and checking account to do their shopping because prices are higher. What you see with the rising price level is an
increase in demand for money.
The increase for demand in money, however, is frustrated because the Fed has not increase the money supply. The
rise in price level increases the demand for money but the supply for money is fixed. Therefore, the excess demand
for money is resolved by a higher interest rate. The price of money goes up so people are content to hold the cash
and checking balances that they have. The rising interest rates as an effect on business spending. Businesses are
not interested in doing as much purchase of capital goods whenever interest rates are high because finance charges
are higher and therefore investment spending falls.
Businesses are not buying as many capital goods, they are not building as many new factories, and they're not
outfitting them with equipment. So, because of the reduced demand for investment goods, businesses cut back their
output of investment goods. That means that real domestic gross product is going to shrink. The second channel
through which rising prices lead to shrinking real gross domestic product is the investment spending effect, rising
prices, increased demand for money, increasing interest rates, shrinking investment spending, and shrinking real
gross domestic product.
The third channel through which rising prices lead to shrinking real gross domestic product is through the effect on net
exports. When price levels rise, foreigners look at the price of goods and services in our economy and compare them
with the prices of goods and services elsewhere. They say, “Hey, it's no bargain to buy stuff from that economy
anymore; let's buy our goods from another country.” Our net exports shrinking as foreigners seek bargains in other
Aggregate Demand/Aggregate Supply Model
Aggregate Demand
Movement Along the Aggregate Demand Curve
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countries. Since our net exports are falling, since people from abroad are no longer buying our goods and services
but buying them from somewhere else instead, then our factories here see that there is less demand and they reduce
their output and real gross domestic product then shrinks. So, the third effect is through the effect on net exports,
rising prices deter foreigners from buying our products, and when net exports shrink, real gross domestic product falls
also.
So, there are three effects. All three of these effects are summarized in the aggregate demand curve. The aggregate
demand curve shows the relationship between the aggregate price level in our economy and our real gross domestic
product. When the aggregate price level rises, there are three consequences. Consumers see their real wealth
shrinking and they buy less. Businesses, because of the increased demand for money, see interest rising and they
buy less. Foreigners see that our prices are high relative to the prices in other countries and they buy less. With all
three of these reductions in demand, we get a reduction in real gross domestic product and our economy. That is why
the aggregate demand curve slopes downwards.
That leads us to one final question. This is often a point of confusion. How is the aggregate demand curve related to
a demand curve from microeconomics? Suppose here we have a demand curve like we draw in the microeconomics
course. Maybe it's the demand curve for onions. On the vertical axis, we have the price of onions. On the horizontal
axis, we have the quantity of onions demanded. Think of what this curve is telling us. When the price of onions rises,
people are willing and able to buy or fewer onions, therefore the quantity demanded of onions decreases.
The demand curve in microeconomics is about two effects: the substitution effect and the income effect. The
substitution effect says that when the price of onions rises, onions are not as interesting anymore because of their
opportunity costs have gone up so you buy carrots or radishes instead. The income effect says when the price of
onions goes up then your purchasing power is shrinking, the purchasing power of your income. Therefore, you buy
fewer onions and less of everything else as well. That is the microeconomics story. It's about opportunity costs and
purchasing power.
The macroeconomic story, on the other hand, is different. On the vertical axis, we do not have the price of any
particular good, we have the aggregate price level, the prices of all goods and services including your income. On the
horizontal axis, we have the output, the overall output and demand in the economy. What this curve is telling us is
that if the overall price level goes up, the price of everything going up that overall demand in the economy is shrinking.
The story has nothing to do with opportunity costs. It has more to do with the relationship between the price level and
other nominal variables. When the price level goes up, your savings account has less purchasing power, you feel less
wealthy and consumers respond to that. When price level goes up, you want more money, another nominal stock in
the economy. Since there isn't anymore, than interest rates rise and businesses respond to that. Also, you can
compare the price level in our economy with the price level in other economies, and foreigners respond to that.
The issue with the macroeconomic demand curve is that the relationship between the overall price level and the
overall output in the economy is because price levels influence the real value of other nominal variables like the
money stock or like savings accounts and other measures of wealth. Don't confuse the microeconomics demand
curve for onions with the macroeconomic demand curve that is talking about how the overall price level effects real
gross domestic product.
Now that we have the aggregate demand curve drawn and now that we understand what it means to move along it,
we can talk about what shifts the aggregate demand curve. This takes us one step closer to completing a model of
the macroeconomy.