-Aggregate Demand: A schedule or curve that shows the amounts of real output (real GDP) that buyers collectively desire to purchase at each possible price level.
-In other words, AD = C + I + G + NX
-Graphing aggregate demand: A downward sloping curve with the price level on the Y-axis and real GDP (Y) on the X-axis.
-Demand for an individual good or service slopes downward because of the income effect and substitution effect. These don’t apply to the explanation of aggregate demand because we’re talking about price levels, not individual prices. (Substitution effect is based on a similar product being cheaper than another; doesn’t work if everything becomes cheaper when price levels fall. Income levels in general fall as well, so there is no income effect).
-Aggregate demand is downward sloping because of 3 effects: the real balances effect, the interest rate effect, and foreign purchases effect.[break]
Real Balances Effect
-Rising price levels (inflation) decreases the purchasing power of assets with fixed dollar values like savings accounts, bonds, and annuities. This decreased purchasing power means that the public is now poorer, which leads to decreased consumption, which leads to a lower level of aggregate demand (AD (down) = C (down) + I + G + NX).[break]
Interest Rate Effect
-Assuming a fixed level of money supply, when price levels go up, the demand for money goes up (as people now need more dollars to purchase the same amount of goods). This increase in money demand leads to an increased interest rate. Higher interest rates means that firms now have a smaller portfolio of projects that have a high enough expected rate of return to borrow against, so they will undertake fewer projects and consequently have lower investment spending. At the same time, consumer related purchases that are dependent on interest levels (like buying a home or a car) also decrease because it is now more expensive to purchase the same good. This decrease in consumption and investment spending leads to a lower level of aggregate demand (AD (down) = C (down) + I (down) + G + NX).[break]
Foreign Purchases Effect
-When domestic price levels rise relative to foreign price levels, domestic goods become relatively more expensive and foreign goods become relatively cheaper. This leads to fewer domestic goods being exported and more foreign goods being imported, leading to decreased net exports which lower the level of aggregate demand (AD (down) = C + I + G + NX (down)).