Short on time? This page is the recap. For explanations, diagrams and worked examples, use the full study guide.
Recap
- Aggregate demand is the relationship between the price level and the quantity of real GDP that households (C), firms (I), the government (G) and the rest of the world (NX) want to buy.
- Axes: Price level (PL) on the vertical axis, Real GDP (Y) on the horizontal axis.
- The AD curve slopes downward because of three effects, not because buyers switch between goods.
- A change in the price level gives a movement along AD. A change in spending for any other reason shifts AD.
Key relationships
| Effect or shifter | Chain of reasoning | Result |
|---|---|---|
| Real wealth effect | PL ↑ → real value of money and savings ↓ → C ↓ | Move up along AD |
| Interest rate effect | PL ↑ → demand for money ↑ → interest rates ↑ → I ↓ | Move up along AD |
| Exchange rate effect | PL ↑ → interest rates ↑ → currency appreciates → exports ↓, imports ↑ → NX ↓ | Move up along AD |
| Consumer wealth or confidence ↑, income taxes ↓, transfers ↑ | C ↑ at every PL | AD shifts right |
| Business expectations ↑, policy interest rates ↓, business taxes ↓ | I ↑ at every PL | AD shifts right |
| Government buys more goods and services | G ↑ at every PL | AD shifts right |
| Foreign incomes ↑, currency depreciates (not caused by PL) | NX ↑ at every PL | AD shifts right |
The opposite change in each shifter shifts AD left.
Assumptions behind the model
- Real GDP is measured at constant (base-year) prices.
- Along one AD curve, everything except the price level is held constant.
- G is set by government decisions and does not respond to the price level here.
- The size of a shift is the subject of Topic 3.2 (multipliers).
Mistakes to avoid
- Price and Quantity as axis labels. Write Price level and Real GDP.
- Saying a higher price level decreases AD. It decreases the quantity of real GDP demanded.
- Using substitution between goods to explain the slope.
- Treating a policy rise in interest rates as a movement. It shifts AD left.
- Saying a tax cut raises G. It raises disposable income and so C.
- Forgetting that imports are subtracted: more imports lower NX.
Quick self-check
- Valdoria’s price level falls. Shift or movement? (Movement down along AD; quantity of real GDP demanded rises.)
- At one price level, C = 700, I = 150, G = 250 and NX = −30 (VD billion). What is the quantity of real GDP demanded? (VD 1,070 billion)
- Real GDP demanded is VD 20 billion higher at every price level. What happened to AD? (It shifted right by VD 20 billion.)
- Which effect links a higher price level to lower investment? (The interest rate effect.)
Next: practice questions.