Derivation of the Aggregate Demand Curve

St. Charles County Community College ECON 110 Principles of Macroeconomics We start with an aggregate demand curve, and we pick two points on that curve, points a and b.

Comments: There are two approaches that can be used for this derivation: The consumption approach (we will refer to it as the consumption link) . The investment approach (we will refer to it as the investment link).

Action
o

Then
o

Because
o

We start out by assuming that prices are rising. When demand for money balances increase..... The interest rate rises....

When prices rise, the demand for money shifts to the right. The interest rate increases also. Consumption decreases.

Consumers need additional money for their everyday transactions.

The money supply has not changed.

At higher interest rates consumers will think about purchasing interest bearing money instruments such as bonds and certificates of deposit.They will forgo consumption to take

advantage of the higher interest rates.

o

Consumption decreases....

Aggregate demand goes down as does real GDP. National output, Y, decreases.

Consumption is the major component of aggregate demand and real GDP. (GDP=C+I+G+Net Exports) Because of the definition of National Output. Comment: We have now shown why national income, Y, is low or decreasing when the price level is high or rising. We have now located point a on our curve.

Real GDP decreases....

The Consumption Link, Continued:

Action
o

Then
o

Because
o

Again, we start out by assuming that prices are falling When demand for money balances decrease... The interest rate falls....

When prices fall, the demand for money shifts to the left. The interest rate decreases also. Consumption increases.

Consumers need less additional money for their everyday transactions.

The money supply has not changed.

At lower interest rates consumers will not be as interested in purchasing interest bearing money instruments. They will forgo the investments because consumption is more attractive to them. Consumption is the major

Consumption

Aggregate

increases....

demand increases as does real GDP. National output, Y, increases.

o

component of aggregate demand and real GDP. (GDP=C+I+G+Net Exports) Because of the definition of National Output. Comment: W e have now shown why national income, Y, is high or increasing when the price level is low or falling. We have now located point b on our curve.

Real GDP increases....

We have now located the two points. When they are connected we have an Aggregate Demand curve.

And, we have tied the money market into the goods market through the consumption link.

Now lets develop the investment lin We use the same sketch that we used for the consumption link.

Action
o

Then
o

Because
o

We start out by assuming that prices are rising. When the demand for money balances increase.... The interest rate rises...

When prices rise, the demand for money shifts to the right. The interest rate also rises.

Consumers and firms need additional money for their everyday transactions.

The money supply has not changed.

Investment decreases.

At higher interest rates households and firms will be hesitant to make investments. Households will hold back on housing purchases, car loans, and

major purchases that are made with mortgages or with credit. Firms will be hesitant to purchase new plant and equipment. Investors will be hesitant to proceed with plans on such projects as apartment buildings, sub-divisions, and commercial buildings. Governments will be hesitant to issue bonds for infrastructure improvements because of the higher interest rates they must pay.
o

Investment decreases...

Aggregate demand goes down as does real GDP. National output, Y, decreases.

Investment and government are components of aggregate demand and real GDP. GDP=C+I+G+Net Exports. Because of the definition of National Output. Comment: We have now shown why national income, Y, is low or decreasing when the price level is high or rising. We have now located point a on our curve.

Real GDP decreases....

The Investment Link, Continued:

Action
o

Then
o

Because
o

We start out by assuming that prices are falling. When the

When prices fall, the demand for money shifts to the left. The interest

Consumers and firms need less money for their everyday transactions.

The money supply has not

demand for money balances decrease....

o

rate also decreases.

changed.

The interest rate decreases...

Investment increases.

At lower interest rates households and firms will be prone to make investments. Households will be seeking home mortgages, car loans, and major purchases on credit. Firms will be interested in purchasing new plant and equipment. Investors will be interested in proceeding with plans on such items as apartment buildings, subdivisions, and commercial buildings. Governments will be interested in issuing bonds for infrastructure improvements because of the lower interest rates they must pay. Investment and government are components of aggregate demand and real GDP. (GDP=C+I+G+Net Exports). Because of the definition of National Output. Comment: We have now shown why national income, Y, is high or increasing when the price level is low or falling. We have now located point b on our curve.

Investment increases...

Aggregate demand increases as does real GDP. National output, Y, increases.

Real GDP increases....

Again, we have located the two points. When they are connected we have an Aggregate Demand curve.

And, we have tied the money market into the goods market through the investment link.

The Aggregate Demand Curve: A Warning

An important point to note is that the aggregate demand curve is markedly different from a market demand curve for a particular good or service. On a market demand curve, only the price of the product and its quantity are allowed to vary. Everything else is held constant (income, the price of other goods, and so on). The aggregate demand curve is not even the sum of all individual market demand curves for an economy. To see why the AD curve is different than a market demand curve, let us examine why market demand curves have a negative slope and contrast this with the reasons for the downward sloping AD curve. To make the picture a little more concrete, let us pick a particular good, say rye bread, to illustrate the properties of a market demand curve. There are two main reasons why a market demand curve has a negative slope. The first is known as the substitution effect. If the price of rye bread increases, for example, it becomes more expensive than before relative to other goods. (Because all other prices are held constant, an increase in the price of rye bread makes it relatively more expensive than before the price rise. People will substitute rye bread, to some degree, with other types of bread, rolls, crackers, or other substitutes. Thus, an increase in the price of rye bread will lead to a reduction in quantity demanded. The second reason market demand curves have a negative slope is known as the income effect. Recall that when drawing a market demand curve, income is held constant. With income held constant, an increase in a goods price means that consumers will not be able to buy as much of it as before while maintaining their purchases of other products. Thus, an increase in the price of a good will reduce the quantity demanded of the good. The AD curve, on the other hand, has a negative slope for different reasons. There cannot be any substitution or income effects here. There cannot be a substitution effect because we include all goods on the horizontal axis and all prices on the vertical axis. With all goods accounted for, all substitutions between goods are accounted for. Similarly, there cannot be an income effect because income (aggregate output) is not held constant in the case of the AD curve. It is allowed to change by virtue of the fact that aggregate output (income, Y) is on the horizontal axis. So why does the AD curve have a negative slope? We described one reason earlier in this lecture. With an increase in the price level, money demand increases and interest rates rise, causing a decline in investment and aggregate output. The other reasons for the negative slope of the AD curve are examined next.

Other Reasons for a Downward-Sloping Aggregate Demand Curve

Just as with planned investment, consumption spending by households is inversely related to the interest rate. With the increase in interest rates stemming from higher prices and increased money demand, consumption spending will fall. As with planned investment, a decline in consumption will cause aggregate output to decline. The response by investment and consumption spending to changes in interest rates stemming from changes in the price level is known as the interest rate effect. Another reason for the negatively sloping AD curve is known as the real wealth effect or the real balance effect. Recall that when we derived the AD curve, monetary policy was held constant. With a given

amount of money in the economy, an increase in prices means that fewer goods and services can be bought than before the price rise. With fewer products purchased, fewer products will be made. Thus, aggregate output will decrease with an increase in the price level.

Deriving the Aggregate Demand Curve

We start our examination of the link between the price level and aggregate output with the money market. A change in the price level affects money demand. An increase in the price level will increase the demand for money and cause the money demand curve to shift to the right. This causes the interest rate to increase, which causes a reduction in planned investment. Aggregate output will decrease in response to the decline in investment by more than the initial decline in investment due to the multiplier effect. This chain of events is illustrated below:

This whole process works in reverse as well. A decrease in the price level will lower money demand and the interest rate. Planned investment will increase in response to the lower interest rate and cause aggregate output to increase by more than the increase in investment. What we have demonstrated, then, is an inverse relationship between the price level and aggregate output. This relationship is what is depicted by the aggregate demand curve. The AD curve plots varying price levels and their corresponding levels of aggregate demand. In other words, each price level and its corresponding level of aggregate output plots as a point on the AD curve, as illustrated below: