Understanding the Concept of Aggregate Demand

The aggregate demand graphically shows the number of goods and services that consumers, the government, businesses and foreign buyers are will to collectively purchase at each possible price level. It is important to note that the curve does not show the demand for one individual product, but the average of all the goods and services. So with other things equal the lower the average level of prices the greater the amount would be purchases. Conversely, the higher the average level of prices, the lower the amount of real gross domestic product purchases so we have an inverse relationship between the price level and real GDP.

The slope of the aggregate demand curve is downwards towards the right or negative for the mathematically minded. The rationale for this being true is not the same as the downward sloping demand curve of an individual product, which was the income and substitution effect. The aggregate demand curve shows the average prices of ALL goods and services so the substitution effect is not applicable. Likewise, for the income effect, income is varying for the aggregate demand curve while its fixed for an individual’s demand curve.

The slope of the aggregate demand curve is downwards because of the following reasons, the interest rate effect, real-balances effect, and foreign purchases effect.

The interest-rate effect’s rationale lies in the impact of increasing average prices on inflation. If the average price for goods and services rise, then the Reserve Bank of Australia (RBA) which was given the task of controlling inflation will increase interest rates to cut consumption and investment spending. How this works is simple, if the RBA charges the banks a higher interest rate, then the banks and lenders will pass that onto their customers, and so consumers would have to cut back on their spending as more of their income will go into repaying interest. Basically, higher prices, decreases the purchasing power of consumer’s current incomes and so they would demand for a pay rise and that increases the demand for money. And a company, if it was to meet those demands, will have a higher cost of production and therefore reduce output and lift their prices. So by raising the interest rate, average prices will rise and that will cause a reduction in the amount of real output demanded.

Another reason would be the wealth effect or the real-balances effect. The rationale is that if an economy goes to a higher price level, then the real value of fixed money value assets will diminish and the public is no relatively poorer in real terms than before and so therefore families will cut back on their consumption because their purchasing power has diminished. Fixed money value assets include savings accounts (those that does not pay interest) and bonds. This can go the other way as well, if there is a decline in the price level, then the value of savings accounts and other accumulated financial assets will increase and so a household’s disposable income will increase and consumption will rise accordingly.