The Aggregate Demand Curve

Aggregate Demand Curve

• First, the price level is measured on the vertical axis and real production (or more specifically aggregate expenditures on real production) is measured on the horizontal axis. The price level is measured by the GDP price deflator and real production is measured by real GDP.


• Second, this aggregate demand curve has a negative slope. The aggregate expenditures that the four sectors of the economy make at higher price levels are relatively low. However, at lower price levels, aggregate expenditures are greater.


• Third, the price level and aggregate expenditures on real production are the only two variables allowed to change in the construction of this curve. Everything else that could affect aggregate demand is assumed to remain constant. Analogous to market demand, these other variables are ceteris paribus factors that fall under the heading of aggregate demand determinants.


• Fourth, this aggregate demand curve captures the relation between the price level and real production during a given time period, usually one year. However, depending on the particular aggregate market analysis, the time period could be shorter (one month or one quarter) or longer (several years).

Moving Along the Aggregate Demand Curve

Along the Curve

Movement along the aggregate demand curve is attributable to three key effects:

• Real-Balance Effect: This occurs when a change in the price level changes aggregate expenditures on real production due to a change in purchasing power of money. In other words, members of the household, business, government, and foreign sectors simply cannot buy as much production with the quantity of money available.


• Interest-Rate Effect: This is a change in investment expenditures or consumption expenditures triggered by a change in the interest rate that is itself triggered by a change in the price level.


• Net-Export Effect: This is a change in net exports, and thus aggregate expenditures, that results because a change in the price level alters the relative prices of exports and imports.

In the analysis of the aggregate market, the price level generally changes in response to a disequilibrium in the economy. The change in the price level then leads to changes in aggregate expenditures and a movement along the aggregate demand curve, which is the mechanism that restores equilibrium. The key is that price level changes CAUSE movements along the aggregate demand curve.

Shifting the Aggregate Demand Curve

Shifting the Curve

Shifts of the aggregate demand curve, brought about by such things as fiscal or monetary policies, changes in investment expenditures, or changes in consumer confidence, are often the source of disequilibrium in the aggregate market. Such disequilibrium then cause changes in the price level. The key is that aggregate demand determinants CAUSE shifts of the aggregate demand curve which CAUSE disequilibrium which then CAUSES changes in the price level.

The aggregate demand curve is shifted due to changes by any (ceteris paribus) factor other than the price level. A short list includes:

• Interest Rate: This determinant includes any change in the interest rate, other than that triggered by a change in the price level, which then causes changes in investment expenditures and consumption expenditures. Higher interest rates reduce expenditures and lower interest rates increase expenditures.


• Inflationary Expectations: This determinant results if consumers expect a different inflation rate in the near future, which then causes a change in current consumption expenditures. Expectations of greater inflation increase expenditures and expectations of less inflation decreases expenditures.


• Money Supply: This determinant is based on a change in the money supply, which then induces changes in expenditures by all four sectors. If the money supply increases, then expenditures rise, if the money supply decreases, then expenditures fall.


• Consumer Confidence: This determinant results when the confidence consumers have concerning the state of the economy changes. If consumers are optimistic about the state of the economy, then they are likely to increase expenditures. If consumers are pessimistic about the state of the economy, then they are likely to decrease expenditures.