Aggregate Demand is the total quantity of goods and services demanded by households, firms, and the government. The aggregate demand curve is downward sloping. Thus, ceteris paribus, a fall in the economy's overall price level tends to raise the quantity of goods and services demanded.


  PRICE     N
  LEVEL     N                                                  AGGREGATE-  
            N      (NN.                                .NN)      SUPPLY
            N        (NN.                            .NN)
            N          (NN.                        .NN)
            N            (NN.                    .NN)
            N              (NN.                .NN)
            N                (NN.            .NN)
            N                  (NN.        .NN)
            N                    (NN.    .NN) 
            N                      (NN..NN)                  
            N                       (NNNN)
            N                       .N)(N.
            N                     .NN)  (NN.   
            N                   .NN)      (NN. 
            N                 .NN)          (NN.       
            N               .NN)              (NN.    
            N             .NN)                  (NN. 
            N           .NN)                      (NN.         
            N         .NN)                          (NN.
            N       .NN)                              (NN.       AGGREGATE-
            N     .NN)                                  (NN.       DEMAND
            N    NN)                                      (NN
            N      
            N    
            NNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNNN

                                    QUANTITY 
                                      OF 
                                    OUTPUT

Why the Aggregate Demand Curve Is Downward Sloping:

    Pigou's Wealth Effect: A decrease in the price level makes consumers feel more wealthy, which then encourages them to spend more. Thus the increase in spending causes there to be a greater quantity of goods and services demanded. Imagine you have twenty dollars. The nominal value of it is fixed ($20), but the real value is not. When the price level falls, the money you have becomes more valuable because it can be used to buy more goods and services, and so this increased wealth leads to an increase in the quantity of goods and services demanded. On the graph below,
    Keynes' Interest-Rate Effect: A lower price level reduces the interest rate and encourages greater spending on investments, and thus increases the quantity of goods and services demanded. If the price level falls, households will need to hold less money to purchase goods and services. Therefore, they may deposit excess money into an interest bearing savings account, and as more households do this, they will drive down the interest rate. This in turn will encourage borrowing by firms that wish to invest in equipment and factories, which leads to an increase in the quantity of goods and services demanded.
    Mundell-Fleming's Exchange Rate Effect: When a fall in US price level causes US interest rates to fall, the real exchange rate depreciates, and this depreciation stimulates the US net exports and thus increases the quantity of goods and services demanded. If US interest rates become too low, some investors will seek higher returns by investing abroad. This will cause an increase in supply of dollars in the foreign currency exchange. This, in turn, will cause a depreciation of the dollar. Because of this depreciation, relative to US goods, foreign goods become more expensive. Therefore, net exports will increase, which leads to an increase in the quantity of goods and services demanded.

Why the Aggregate Demand Curve Might Shift:

    Change in Monetary Policy: An increase in the money supply reduces the equilibrium interest rate for any price level. A lower interest rate stimulates investment spending, which shifts the curve to the right. Conversely, a decrease in the money supply raises the equilibrium interest rate, which shifts the curve to the left.
An increase in government spending or a cut in taxes shifts the Aggregate Demand curve to the right. A decrease in government purchases or an increase in taxes shifts the Aggregate Demand curve to the left.
    The Multiplier Effect: The additional shifts in Aggregate Demand resulting from an expansionary fiscal policy. Consider this example: If the government buys $20 billion dollars of goods from McDonnell Douglas, both employment and profits will be rasied at McDonnell Douglas. Both the workers and owners will begin to see higher profits and will respond by increasing their own consumption of goods. Thus, not only does the government's spending increase the Aggregate Demand, but also the increase consumption of workers and owners due to higher income.
    The Crowding-Out Effect: The offset in Aggregate Demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending Let's look at our example of McDonnell Douglas again. Instead this time, the households plan to buy goods and services in the future, and so they hold more of their wealth in liquid form, which means there is an increase in the demand for money. Because the Fed has not changed the supply of money, the vertical supply remains the same, and so the money demand curve shifts to the right and the interest rate increases to achieve equilibrium. Because of the increased interest rate, there is less incentive for firms to borrow money to invest, thus shifting the Aggregate Demand curve to the left.

The government has a great deal of power with Fiscal Policy, and the Fed with Monetary Policy, to influence the Aggregate Demand. Economists disagree to what extent the government should be active in such affairs, but it should also be noted that the effects of Monetary Policy and Fiscal Policy depend on the time span. The AD effects on output emphasized here only hold out in the short run, where prices are sticky. In the long run, output is determined by factor supplies and technology.

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