Aggregate Demand by Omkar Abhyankar

 In previous articles, we have discussed measuring the supply and demand for a particular good. Pursuing this measurement allows for economists to study the current state of a particular market and understand the relationships between the buyers of the market and the sellers of the market. When the producers or consumers in the market seem to struggle, economists can inform the government to intervene and help out the certain sector of the market through price ceilings or price floors. However, we know that this definition of supply and demand is restricted to specifically one type of good. Economists have decided upon a variation of our typical supply and demand model. They came up with the concepts of “aggregate demand” and “aggregate supply”, where the word aggregate means total. This demand and supply model allows economists to understand the total demand for all goods and services and the total supply for all goods and services in the economy. By measuring the aggregate demand and aggregate supply, economists can understand at a macro level the overall level of productions and consumptions of all goods and services occuring in an economy. They can use this knowledge to understand why an economy is facing a recessionary gap or an inflationary gap and intervene accordingly. In this article, we will focus on the concept of aggregate demand.

Aggregate demand measures the overall demand for all goods and services across various price levels. In other words, when measuring the aggregate demand, we are taking the demand of each individual good or service and putting it together to form the aggregate demand. Let’s take a graphical approach to better understand this concept.

Based on this graph, we see that the x-axis is labeled “Real GDP” and the y-axis is labeled “Price Level”.  Recall that real GDP measures the total amount of goods and services produced within an economy. The x-axis is measuring how much of those goods being produced are actually being consumed. It is important to note that the x-axis is not actually measuring the real GDP but is rather using the real GDP to measure how many goods are being bought. The y-axis is labeled “Price Level” instead of just price since it is measuring the overall prices of all the economy’s goods and services rather than just one good or service. The curve is labeled “AD” to represent the aggregate demand. Let’s analyze Point A on the curve to better understand what aggregate demand is measuring. At Point A, we can see that the x-axis value is 200 billion and the price level is $320. This means that at Point A in this economy, 200 billion goods are being bought at an average value of $320. 

Now, let’s take a closer look at the curve itself. We can see that it is downwards sloping therefore modeling an inverse relationship between the price level and the quantity demanded of all the goods and services produced. Why is that? Economists have come up with three reasons to explain this characteristic of aggregate demand.

1. Wealth Effect:

The first reason is called the “Wealth Effect”. This reason involves the idea of consumers’ wealth changing as price levels change. As price levels begin to fall, consumers are essentially wealthier since now they are able to buy more goods and services since they are cheaper. This would cause an increase in the quantity demanded for these goods and services, modeling that inverse relationship between the price level and the quantity of goods and services demanded. Conversely, if price levels rise, then consumers are essentially less wealthy as now they are unable to purchase as many goods and services as they once were able to. Therefore the quantity of goods and services demanded would decrease also modeling that inverse relation between the price level and the quantity of goods and services demanded.

2. Interest Rate Effect:

The second reason is called the “Interest Rate Effect”. This reason involves the amount of money consumers can save. If the price level falls, then consumers do not have to spend as much on their goods and services since everything is cheaper, therefore, allowing them to save a lot of their money. When those consumers save their money, they give it to the bank and the bank lends that money to other consumers. If all consumers begin to save more money, then the bank has more money to lend out which ultimately decreases the cost of burrowing, the interest rate. If the interest rates have decreased, then consumers can now borrow more money and purchase more goods and services, ultimately increasing the quantity of goods and services demanded in the economy, modeling that inverse relationship between the price level and the quantity of goods and services demanded. Conversely, if the price level rises, then consumers have to spend more on their goods and services and are unable to save as much money. This means that banks have less money to lend out, thereby increasing the interest rate. Now that the cost of borrowing, the interest rates, have risen, consumers are unable to borrow as much money and therefore are unable to consume as many goods and services, ultimately decreasing the quantity demanded for the economy’s goods and services and modeling that inverse relationship between the price level and the quantity of goods and services demanded. We will dive more deeper into the money supply, banking and interest rates in future articles.

3. Exchange Rate Effect

The third effect is called the “Exchange Rate Effect”. This third reason considers making purchases abroad. When the price level in one country increases, its consumers will purchase their goods and services from other countries since commodities would be cheaper abroad, ultimately decreasing the quantity of goods and services demanded in that highly priced country. Conversely, if the price level in a country decreases, then its consumers will make domestic purchases rather than purchasing abroad since the domestic prices are cheaper. As a result, the quantity demanded for goods and services within this country would increase once again modeling that inverse relationship between the price level and the quantity of an economy’s goods and services demanded.

In the next article, we will take a look at the factors which can cause an economy’s aggregate demand to change.