3.1 — Aggregate Demand

Aggregate demand is the demand for all the different items in the economy. As a result, since we’re evaluating many different items, we use the Price Level on the y-axis and the Real GDP on the x-axis. The aggregate demand is do wnward sloping for 3 reasons:

1. Real Wealth Effect: As the price level falls, consumers’ assets have more purchasing power so they buy more (leading to a bigger Real GDP). In contrast, as the price level increases, consumers’ assets have less purchasing power so they buy less.
2. Interest Rate Effect: As the price level goes up, people buy less but they also save less, which means less money in banks and less lending. These higher interest rates and less investment spending lead to a decrease in the quantity of goods and services demanded, which decreases Real GDP. In contrast, more purchasing power and spending also means more money saved for consumers, which decreases interest rates and increases investment spending.
3. Exchange Rate Effect: When prices in one country are raised, other countries don’t buy from the country, so quantity demand ends up falling. When the price level falls, other countries want to purchase more, which correspondingly increases the Real GDP.

Ultimately, these three effects stem from the three makers of the market: the Real Wealth Effect dictates consumer behaviour, the Interest Rate Effect accounts for investor/lender behaviour, and the Exchange Rate Effect defines the behaviour of other countries (importers/exporters). All three show an inverse relationship between Price Level and GDP Demanded.

Shifting the Aggregate Demand Curve

Anything that affects:

• $C$: Consumer Spending
• $I$: Investment Spending
• $G$: Government Spending
• $X_n$: Net Exports will shift the aggregate demand curve.