For one good, demand slopes down: a higher price, and buyers want less. Aggregate demand looks similar, but it plots something different: the total real GDP that households, firms, government and foreigners want to buy (C + I + G + NX) at each price level, measured by a Price Indexes and the CPI.
Key idea
Aggregate demand (AD) slopes down. A lower price level raises the quantity of real GDP demanded because of three effects: the wealth effect, the interest-rate effect and the exchange-rate (foreign purchases) effect. A change in the price level is a movement along AD.
Why it works
When the whole price level falls, there is no cheaper domestic good to switch to, so the single-market reason does not apply. Instead: (1) Wealth: the money and savings people hold buy more, so they feel richer and spend more. (2) Interest rates: people need less money for their purchases and lend out the rest, interest rates fall, and firms and families borrow to buy machines, homes and cars. (3) Exchange rate: our goods get cheaper next to foreign goods, so exports rise and imports fall. A higher price level runs all three in reverse.
| Effect | Price level rises → | Spending that falls |
|---|---|---|
| Wealth | savings and cash buy less | consumption (C) |
| Interest rate | money demand and interest rates rise | investment (I), some C |
| Exchange rate | our goods dearer than foreign goods | net exports (NX) |
Worked examples
Worked example: Naming the effect
The price level rises, so people need more money for purchases. Interest rates climb and a firm postpones building a warehouse. Which effect is this?
- The story runs through money demand and interest rates.
- Higher rates cut investment: the interest-rate effect, a movement up along AD.
Answer: The interest-rate effect
Worked example: Moving along AD
Along an AD curve, real GDP demanded is $Y = 30 - 0.1P$ (trillions of dollars). The price level rises from 110 to 130. How does real GDP demanded change?
- At $P = 110$: $Y = 30 - 11 = 19$. At $P = 130$: $Y = 30 - 13 = 17$.
- Real GDP demanded falls by 2 trillion: a movement up along AD, not a shift.
Answer: Falls by \$2 trillion
Common mistake
Explaining the slope of AD with the substitution effect from a single market ("people switch to other goods"). When the whole price level rises there is nothing cheaper at home to switch to. Check: your reason should involve wealth, interest rates or foreign trade.