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[link] presents an aggregate demand (AD) curve. Just like the aggregate supply curve, the horizontal axis shows real GDP and the vertical axis shows the price level. The AD curve slopes down, which means that increases in the price level of outputs lead to a lower quantity of total spending. The reasons behind this shape are related to how changes in the price level affect the different components of aggregate demand. The following components make up aggregate demand: consumption spending (C), investment spending (I), government spending (G), and spending on exports (X) minus imports (M): C + I + G + X – M.

The aggregate demand curve

The graph shows a downward sloping aggregate demand curve.
Aggregate demand (AD) slopes down, showing that, as the price level rises, the amount of total spending on domestic goods and services declines.

The wealth effect holds that as the price level increases, the buying power of savings that people have stored up in bank accounts and other assets will diminish, eaten away to some extent by inflation. Because a rise in the price level reduces people’s wealth, consumption spending will fall as the price level rises.

The interest rate effect is that as prices for outputs rise, the same purchases will take more money or credit to accomplish. This additional demand for money and credit will push interest rates higher. In turn, higher interest rates will reduce borrowing by businesses for investment purposes and reduce borrowing by households for homes and cars—thus reducing consumption and investment spending.

The foreign price effect points out that if prices rise in the United States while remaining fixed in other countries, then goods in the United States will be relatively more expensive compared to goods in the rest of the world. U.S. exports    will be relatively more expensive, and the quantity of exports sold will fall. U.S. imports    from abroad will be relatively cheaper, so the quantity of imports will rise. Thus, a higher domestic price level, relative to price levels in other countries, will reduce net export expenditures.

Truth be told, among economists all three of these effects are controversial, in part because they do not seem to be very large. For this reason, the aggregate demand curve in [link] slopes downward fairly steeply; the steep slope indicates that a higher price level for final outputs reduces aggregate demand for all three of these reasons, but that the change in the quantity of aggregate demand as a result of changes in price level is not very large.

Read the following Work It Out feature to learn how to interpret the AD/AS model. In this example, aggregate supply, aggregate demand, and the price level are given for the imaginary country of Xurbia.

Interpreting the ad/as model

[link] shows information on aggregate supply, aggregate demand, and the price level for the imaginary country of Xurbia. What information does [link] tell you about the state of the Xurbia’s economy? Where is the equilibrium price level and output level (this is the SR macroequilibrium)? Is Xurbia risking inflationary pressures or facing high unemployment? How can you tell?

Price level: aggregate demand/aggregate supply
Price Level Aggregate Demand Aggregate Supply
110 $700 $600
120 $690 $640
130 $680 $680
140 $670 $720
150 $660 $740
160 $650 $760
170 $640 $770

To begin to use the AD/AS model, it is important to plot the AS and AD curves from the data provided. What is the equilibrium?

Step 1. Draw your x- and y-axis. Label the x-axis Real GDP and the y-axis Price Level.

Step 2. Plot AD on your graph.

Step 3. Plot AS on your graph.

Step 4. Look at [link] which provides a visual to aid in your analysis.

The ad/as curves

The figure shows a downward sloping aggregate demand line intersecting with an aggregate supply curve at approximately (680, 130).
AD and AS curves created from the data in [link] .

Step 5. Determine where AD and AS intersect. This is the equilibrium with price level at 130 and real GDP at $680.

Step 6. Look at the graph to determine where equilibrium is located. We can see that this equilibrium is fairly far from where the AS curve becomes near-vertical (or at least quite steep) which seems to start at about $750 of real output. This implies that the economy is not close to potential GDP. Thus, unemployment will be high. In the relatively flat part of the AS curve, where the equilibrium occurs, changes in the price level will not be a major concern, since such changes are likely to be small.

Step 7. Determine what the steep portion of the AS curve indicates. Where the AS curve is steep, the economy is at or close to potential GDP.

Step 8. Draw conclusions from the given information:

  • If equilibrium occurs in the flat range of AS, then economy is not close to potential GDP and will be experiencing unemployment, but stable price level.
  • If equilibrium occurs in the steep range of AS, then the economy is close or at potential GDP and will be experiencing rising price levels or inflationary pressures, but will have a low unemployment rate.

Questions & Answers

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Siti Reply
what is flow variable
Siyanda Reply
a flow is a quantity that can be measured over a specific period of time
is economics a social science or a pure science
Hilda Reply
social science
social science
social Science as a Subject and Pure science as a study
How to compute National income by using the expenditure approach
Bridget Reply
explain the method?
C+I+G+(X-M) C= Consumption Expenditure I= Investment Expenditure G= Government Expenditure X-M = Net Export
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yes !! am here !! Lecturer of Economics And Statistics
Macroeconomics is too vast,so please be specific your question
I need help in statistics my lecturer is too fast at times I dont understand
Briefly explain whether the discipline of economics is a social science or pure science( normative or positive)
Okafor Reply
answer.... Economics is social science
different between absolute advantage and comparative advantage
mathematical economics
masele Reply
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why met worth is added with libilitys in the balance sheet
bijoy Reply
what are the implications of inflation targeting?
Alinaitwe Reply
maximize profit
What happens to the goods and money market if the government cuts public spending?
Harman Reply
then the government will be punished by the public
GDP, INFLATION, UNEMPLOYMENT & PRODUCTIVITY and then write a paragraph on the behavior of each variable after analyzing them graphically.
what is international trade
Stella Reply
International trade is the exchange of capital, goods, and services across international borders.
international trade is the exchange of goods and services across boundaries
international trade is the exchange of goods and services of country and abroad
international is the process of exchanges of value interm of goods and services along national frontier
Increase knowdge and skill. it save time and cost. Increase high Efficiency of production .
betta Reply
List kinds of Elastcity of Demand
Is a faster rate of economic growth always a good thing as compared to a slower rate? And why?
what is unemployment
Doctor Reply
it is a situation during which workers remain jobless.
is situation where people are willing to work but job are no available
what is inflation
Sheila Reply
Inflation is a major concern to global economists, and it affects people from all walks of life. It refers to the measure or rate by which the cost of goods and services rises and purchasing power declines. As prices increase, monetary value decreases—prompting consumers to spend less on goods and s
inflation is the persistence rise in price level
Inflation is the situation during which too much money is required to purchase too few goods.
inflation is continuous increase in general price level
it is the process where too much money pursuing fewer goods

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Source:  OpenStax, Macroeconomics. OpenStax CNX. Jun 16, 2014 Download for free at http://legacy.cnx.org/content/col11626/1.10
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