The aggregate-demand curve
The three facts about booms and recessions, and why the economy's total demand for goods falls as the price level rises.
FinanceThe economy behind your investmentsAbout 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- State Mankiw's three facts about economic fluctuations
- Explain the three reasons the aggregate-demand curve slopes downwards
- Name what shifts aggregate demand
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The economy behind your investments: lesson 5 of 16
- The economy behind your investments
- Financial markets and intermediaries 5 min
- The market for loanable funds 5 min
- Banks and the money supply 5 min
- The quantity theory of money 5 min
- The aggregate-demand curve 5 min
- Monetary policy and aggregate demand 5 min
- Aggregate supply and the business cycle 5 min
- Fiscal policy and the multiplier 5 min
- The Phillips curve 5 min
- Expectations and the cost of lower inflation 5 min
- Rules or discretion 6 min
- Deficits and the case for balance 7 min
- Exchange rates and purchasing-power parity 5 min
- Exports, imports and capital flows 5 min
- The market for foreign-currency exchange 5 min
- Policies and shocks in an open economy 5 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 20
What it is
Economies don't grow smoothly. A recession is a period of falling real incomes and rising unemployment; a severe one is a depression. Mankiw's example: from the end of 2007 to mid-2009, US real GDP fell by 4%, and unemployment rose from 4.4% in May 2007 to 10.1% in October 2009.
Three key facts about fluctuations:
- They are irregular and unpredictable. The "business cycle" is not a regular cycle.
- Most macroeconomic quantities move together: income, spending, production, and especially investment.
- As output falls, unemployment rises.
To explain them, Mankiw uses the model of aggregate demand and aggregate supply: the price level on the vertical axis and real GDP on the horizontal. Unlike the long-run (classical) models earlier in the book, this model allows money and other nominal changes to affect real output in the short run.
The aggregate-demand curve shows the quantity of goods and services that households, firms, the government and foreigners want to buy at each price level. Since Y = C + I + G + NX, it slopes downwards for three reasons:
- The wealth effect (consumption). A lower price level makes the money people hold worth more, so they feel richer and spend more.
- The interest-rate effect (investment). At a lower price level, people need less money for purchases and lend out the rest, which lowers interest rates and encourages investment.
- The exchange-rate effect (net exports). Lower interest rates lead some savers to invest abroad, so the currency depreciates, which makes home goods cheaper and raises net exports.
Quick check
Tap an answer to check it.
The price level falls. Through the interest-rate effect, what happens?
- That is the wealth effect
Show answer
People hold less money and lend more, interest rates fall, and investment rises. The interest-rate effect works through investment.
Why it matters
What shifts aggregate demand. Anything that changes spending at a given price level shifts the whole curve:
- Consumption: a stock-market boom, a tax cut, or a change in how much people want to save.
- Investment: better technology or optimism among firms, an investment tax credit, or a rise in the money supply that lowers interest rates.
- Government purchases: more defence or road spending.
- Net exports: a recovery abroad raising demand for exports, or a change in the exchange rate driven by speculators.
A rise in any of these, at the same price level, shifts aggregate demand to the right.
Note: the aggregate-demand curve is not like the demand curve for a single good. A single good's demand curve slopes down because buyers switch to other goods; that can't explain total demand, since there is nothing else to switch to. The three effects above are the reasons instead.
Worked example
Sort each event by its effect on aggregate demand, and the part of spending it works through:
- A big rise in share prices makes people feel richer: shifts right (consumption).
- Firms become gloomy about the future: shifts left (investment).
- The government builds new motorways: shifts right (government purchases).
- A recession abroad cuts demand for exports: shifts left (net exports).
- The price level falls: a movement along the curve (all three effects).
Text description
An aggregate-demand curve, with the price level up and real GDP across. It slopes down: a lower price level raises the quantity of goods demanded through the wealth, interest-rate and exchange-rate effects; the two dots mark a movement along the curve. A dashed curve to the right shows a rise in aggregate demand, for example from a tax cut or a rise in the money supply: more is demanded at every price level.
Common mistake
Treating a change in the price level as a shift in aggregate demand. A change in the price level moves the economy along the curve; only changes in spending at a given price level shift it.
Key terms
- recession
- a period of declining real incomes and rising unemployment
- depression
- a severe recession
- aggregate-demand curve
- the quantity of goods and services that households, firms, the government and foreigners want to buy at each price level
- wealth effect
- a lower price level raises the real value of money holdings, raising consumption
- interest-rate effect
- a lower price level lowers interest rates, raising investment
- exchange-rate effect
- a lower price level lowers interest rates and the currency's value, raising net exports
Practise the key terms
Tap a card to turn it over. 6 cards.
| Front | Back |
|---|---|
| recession | a period of declining real incomes and rising unemployment |
| depression | a severe recession |
| aggregate-demand curve | the quantity of goods and services that households, firms, the government and foreigners want to buy at each price level |
| wealth effect | a lower price level raises the real value of money holdings, raising consumption |
| interest-rate effect | a lower price level lowers interest rates, raising investment |
| exchange-rate effect | a lower price level lowers interest rates and the currency's value, raising net exports |
Practice
Sort it
Which group does this belong to?
A tax cut for households
Consumption risesShow answer
Shifts aggregate demand right. Consumption rises
The central bank cuts the money supply
Higher interest rates cut investmentShow answer
Shifts aggregate demand left. Higher interest rates cut investment
An investment tax credit
Investment risesShow answer
Shifts aggregate demand right. Investment rises
Households decide to save more of their income
Consumption fallsShow answer
Shifts aggregate demand left. Consumption falls
A boom in a major trading partner
Net exports riseShow answer
Shifts aggregate demand right. Net exports rise
Quick quiz
Tap an answer to check it.
Which of Mankiw's three facts says unemployment rises when output falls?
- That fact is about fluctuations being irregular and unpredictable
Show answer
The third fact. Output and unemployment move in opposite directions.
Why does a lower price level raise net exports, in Mankiw's account?
- The mechanism is through interest rates and the exchange rate
Show answer
Lower interest rates push the currency down, making home goods cheaper abroad. The exchange-rate effect.
Why doesn't the aggregate-demand curve slope down for the same reason as a single good's demand curve?
- That explains one market, not total spending
Show answer
A single good's demand slopes down as buyers switch to other goods; for the whole economy there is nothing else to switch to. The wealth, interest-rate and exchange-rate effects explain it instead.
In short
- Fluctuations are irregular, quantities move together, and unemployment rises as output falls.
- Aggregate demand slopes down because of the wealth, interest-rate and exchange-rate effects.
- Changes in consumption, investment, government purchases or net exports at a given price level shift it.
- A change in the price level is a movement along it.
Mastery check
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Name the three reasons the aggregate-demand curve slopes downwards.
Show answer
The wealth effect, the interest-rate effect and the exchange-rate effect.
What happened to US unemployment from May 2007 to October 2009, in Mankiw's figures?
Show answer
It rose from 4.4% to 10.1%.
Does a fall in the price level shift aggregate demand?
Show answer
No; it is a movement along the curve.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 20.
- On this site: What GDP counts and Aggregate supply and the business cycle.
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