# 23.1: Aggregate Demand

- Page ID
- 32289

learning objectives

- What is the AD curve and why does it slope downward?
- What shifts the AD curve and why?

The IS-LM model isn’t entirely agreeable to policymakers because it examines only the short term, and when pressed into service for the long-term, or changes in the price level, it suggests that policy initiatives are more likely to mess matters up than to improve them. In response, economists developed a new theory, aggregate demand and supply, that relates the price level to the total final goods and services demanded (aggregate demand [AD]) and the total supplied (aggregate supply [AS]). *This new framework is attractive for several reasons: (1) it can be used to examine both the short and the long run; (2) it takes a form similar to the microeconomic price theory model of supply and demand, so it is familiar; and (3) it gives policymakers some grounds for implementing activist economic policies*. To understand aggregate demand and supply theory, we need to understand how each of the curves is derived.

*The aggregate demand curve can be derived three ways, through the IS-LM model**, with help from the quantity theory of money, or directly from its components*. Remember that Y = C + I + G + NX. As the price level falls, ceteris paribus, real money balances are higher. That spells a lower interest rate. A lower interest rate, in turn, means an increase in I (and hence Y). A lower interest rate also means a lower exchange rate and hence more exports and fewer imports. So NX also increases. (C might be positively affected by lower *i* as well.) As the price level increases, the opposite occurs. So the AD curve slopes downward.

*The quantity theory of money also shows that the AD curve should slope downward*. Remember that the quantity theory ties money to prices and output via velocity, the average number of times annually a unit of currency is spent on final goods and services, in the so-called equation of exchange:

M V = P Y

where

M = money supply

V = velocity of money

P = price level

Y = aggregate output

If M = $100 billion and V = 3, then PY must be $300 billion. If we set P, the price level, equal to 1, Y must equal $300 billion (300/1). If P is 2, then Y is $150 billion (300/2). If it is .5, then Y is $600 billion (300/.5). Plot those points and you get a downward sloping curve, as in Figure 23.1 . The AD curve shifts right if the MS increases and left if it decreases. Continuing the example above, if we hold P constant at 1.0 but double M to $200 billion, then Y will double to $600 billion (200 × 3). (Recall that the theory suggests that V changes only slowly.) Cut M in half ($50 billion) and Y will fall by half, to $150 billion (50 × 3).

For a summary of the factors that shift the AD curve, review Figure 23.2 .

key takeaways

- The aggregate demand (AD) curve is the total quantity of final goods and services demanded at different price levels.
- It slopes downward because a lower price level, holding MS constant, means higher real money balances.
- Higher real money balances, in turn, mean lower interest rates, which means more investment (I) due to more +NPV projects and more net exports (NX) due to a weaker domestic currency (exports increase and imports decrease).
- The AD curve is positively related to changes in MS, C, I, G, and NX, and is negatively related to T.
- Those variables shift AD for the same reasons they shift Y
_{ad}and the IS curve because all of them except taxes add to output. - An increase in the MS increases AD (shifts the AD curve to the right) through the quantity theory of money and the equation of exchange MV = PY. Holding velocity and the price level constant, it is clear that increases in M must lead to increases in Y.