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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

which model predicted a global collapse in the world's social and economic system before the year 2010
Francis Reply
what is the formula of mixed income ?
Sanjum Reply
labor force in.Nigeria is seen as .......?
Aisha Reply
Is demand the same as being in need of a product?
Aphiwe Reply
yeah
Demand is defer from only need of products
Zubairu
need is the primary and main root of demand. but demand is the result of combination of need; income capacity and desire to expend of money for that product.
Ramu
products or services
jax
what is price determination?
Alick Reply
why are imports subtructed when GDP is calculated in the expenditure approach
nati
what is fiscalpolicy
nati Reply
The way of the government expenses and other analysis
Zubairu
It explains government spending and how it helps to direct the economy towards the desired direction. For instance, if the govt of a nation is desirous of achieving economic growth and development, then the govt will adopt an expansionary fiscal policy which imply more spending by the govt.
Sunday
and politics party important
mujtaba Reply
politics party important
mujtaba
Which party is that
Zubairu
persons who stopped searching for jobs but would accept if the opportunity presents itself
Torissa Reply
persons who are unemployed whether they are underage, retired or incapacitated
Torissa
the us economy is best characterized as?
Shekeriah
what is the impact of fiscal policy in the short and long run in the AD/AS model...
Hydrammeh Reply
What is demand
Mohd Reply
Demand is the desire for a commodity backed by the willingness and the purchasing power too.
Ajay
what is the impact of the higher tax rate on the business and the economy at large..?
Hydrammeh Reply
aggregate demand decreases and GDP decreases in the long run prices will decrease because aggregate supply will shift to the right and increase
Murabit
Thanks, Murabit
Hydrammeh
But still I will need more explanation
Hydrammeh
no problem tax rate is a form of fiscal policy so any time the government changes spending or taxes it will directly affect the economy
Murabit
but remember that there at different economic views on fiscal policy there is classical,Keynesian and moneterism
Murabit
if taxes increase aggregate demand decreases causing a fall in prices causing a fall in the money demand lowering interest rate and increasing investment spending in turn increasing prices
Murabit
thanks so much Murabit
Hydrammeh
what are the policy recommendations for impact of government borrowing?
Baisiro Reply
how can I get Utility notes here
Tabea Reply
I also want to know
konglan
I have them
Alick
money and money supply
Yogesh Reply
money is anything that is generally accepted as payment of goods and services or that is accepted in settlement of debt.
Rakgadi
Money supply?
Rakgadi
Money supply is the total value of monetary assets available in an economy at a specific time.
Rakgadi
supply of money:- The total quantity of money in an economy at a point of time......
Ittoo
What is the difference between monetary economy and barter economy?
Rakgadi
monetary economy is simply an economy where money acts as a medium of exchange and barter economy is why where goods acts as a medium of exchange
Ittoo
Thank you Ittoo.
Rakgadi
please cut why.....in last ans
Ittoo
and no need of thanks dear
Ittoo
Don't damend work in inflation
Mishael Reply

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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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