Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Following the Aggregate Demand Curve

As the preceding section describes, economists break down aggregate demand into its four constituent components of consumption, investment, government purchases and net exports:

Here you discover how to represent aggregate demand graphically by using the aggregate demand curve (see Figure 7-4) and the importance of

distinguishing between a movement along the AD curve and a shift of the AD curve.


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Figure 7-4: The aggregate demand curve.

The AD curve shows how total demand for goods and services in an economy varies as the price level (the average level of prices in the economy) varies. The AD curve is of interest because it shows the level of demand in an economy at a particular moment in time. A change in economic policy or a change in consumer/firm sentiment is likely to shift AD – thus allowing economists to analyse the effect of different changes.

Even though it’s called an ‘AD curve’, economists often draw it as a straight line – because they’re lazy like that. But seriously, it doesn’t matter whether you draw it as a straight line or a curve; the important thing is that it is

downwards sloping and shows that the total demand in an economy increases as the price level falls while holding everything else fixed. Of course if other things change (like economic policy or sentiment), this will result in a shift in the AD curve.


Figure 7-4 shows that, as the price level falls, aggregate demand increases. This happens for a number of reasons:


The Pigou effect (also called the real balance effect): When the price level falls, the value of individuals’ money holdings rises. That is, you can buy more with the same amount of money. Thus, individuals become wealthier and they respond by consuming more (C increases).


The Keynes effect: The fall in the price level leads to a reduction in the demand for money. Because things are cheaper, you don’t need to hold as much money in order to make purchases. This fall in demand for money reduces the interest rate. A lower interest rate stimulates investment by firms and consumption by households (C and I increase).


The Mundell–Fleming effect: The fall in the (domestic) price level makes domestic goods relatively more attractive compared to foreign goods. This stimulates exports and reduces imports, leading to an increase in net exports (NX increases).


If you’ve come across the supply-and-demand model in


microeconomics before, you may have learnt that the demand curve for

a good slopes downwards because ‘more people are willing to buy at a

lower price’. It’s easy to think that the AD curve slopes downward for

the same reason. But no: the AD curve slopes downwards due to the

three effects we list above.