Aggregate Demand: Definition & Model

Instructor: Shawn Grimsley
Economists often analyze the total demand for goods and services in an economy. In this lesson, you'll learn about aggregate demand and the model economists use to describe it. You'll also have a chance to take a short quiz.

Definition

Aggregate demand is the total quantity of goods and services demanded in an economy at a given price level. If you plot the quantity demanded at each price level on a graph and connect the data points, you'll get what's called an aggregate demand curve. An aggregate demand curve is downward sloping.

Aggregate Demand Model

Let's take a look at how economists believe aggregate demand in an economy behaves. The model explains why the aggregate demand curve slopes down and why an aggregate demand curve may shift.

Downward Slope

A negative relationship exists between price level and demand, which results in a downward-sloping aggregate demand curve. In other words, if everything else remains constant, a decline in price level will increase demand, and an increase in price level will lead to a decrease in demand. Economists believe there are three primary reasons for this negative relationship. Let's take a look at each.

  • The Wealth Effect. Lower prices increase wealth because you have more money left over after making your purchases. This increase in wealth allows you to spend more, which raises demand for goods and services.
  • The Interest Rate Effect. When prices decline, you have more money left over after your purchases. Most people will want to take that left over money and turn it into an interest-generating asset. You may decide to loan a friend money at a rate of interest, or you may decide to dump the money into an interest-bearing savings account where the bank will use it to make loans. Other people and businesses seek to obtain loans to acquire investments such as factories or houses. As funds available for borrowing increase, interest rates will lower as lenders compete for borrowers. Consequently, a lower price level results in lower interest rates, encouraging people and businesses to invest, thereby increasing the quantity of goods and services in the economy.
  • The Exchange Rate Effect. An exchange rate is the rate that you can trade one type of currency for another. For example, you can trade 1 U.S. Dollar for 0.758 Euros. When domestic investors see low interests offered domestically, they may seek investment abroad for a better return. This means they will have to convert Dollars into a foreign currency. As the supply of Dollars increases in the currency exchange market, the value of the Dollar will decline compared to the value of other currencies. Decreases in the value of the Dollar tend to increase foreign demand for goods made in the U.S. because foreigners get more for their Euros, Pounds and Yen. This increase in demand for exports will increase the quantity of goods and services supplied.

Shift in Aggregate Demand

As we discussed earlier, a decrease in the price level for goods and services will cause aggregate demand to increase if all other factors remain unchanged. On the other hand, a shift in demand occurs where the quantity demanded changes even when the price level is unchanged. If the quantity demanded increases at the same price level, the aggregate demand curve shifts to the right, but if the quantity demanded decreases at the same price level, the curve will shift to the left. You can see a demand shift in the illustration below.

Supply Curve

An aggregate demand curve will shift under four general situations. Let's look at each of them.

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