Aggregate Demand Definition – Why AD Curve Downward Sloping?

aggregate demand definition

Aggregate Demand Definition and AD Curve

Aggregate Demand Definition – “Demand of all the households for goods and services in an economy”

At equilibrium, aggregate demand becomes equal to the output produce in an economy.  According to Keynes, the aggregate demand is equal to sum of  consumption of households, Investment, Government expenditure and Net Exports.

AD = C + I + G + (X – M)

where, C is consumption of households

I is the capital investment

G is government spending or expenditure

X is exports and M is Imports

Consumption Expenditure – It refers to money spend on all the final goods and services by the household that are in an economy

Capital Investment – The amount of money than an economy spend on capital assets such as land, building, machinery and other equipment.

Government Expenditure – It includes the government expenditure in buying of goods and services.

Exports – It includes the items sold to the foreign countries.

Imports – This consists of the goods and service purchased from foreign countries.

If  AD < Output produce, unplanned inventory builds up and hence firms will cut the production. Similarly if AD > Y, inventories has deplete below the planned levels. Hence the firms increase the production.

Shape of Aggregate Demand Curve

In order to get the more clear understanding of the aggregate demand definition, let’s have a look over the aggregate demand curve.

The shape of the AD curve is download sloping. There are lots of reasons behind this. The most prominent one is when the price increases the quantity demanded decreases and vice versa. Similarly, with the drop in the price level, the national income or the purchasing power of the people increases.

However, the basic reasons behind downward sloping curve are Pigou’s wealth effect, Keynes interest rate effect and Mundell  exchange rate.

Pigou’s Wealth Effect – According to this effect, when the price level falls, the purchasing power of the consumer increases. In simple words, when the price level decreases, consumers become more rich and wealthy.

Keynes Interest Rate – Well, the quantity demanded depends upon the price level. When the price increases the quantity falls and vice versa. When the prices are high, consumers ask for more money and when the prices are low, consumers ask for less money. In case of lower prices, consumers are able to put more money in the bank. This results in increasing the deposits of the bank. Hence banks provides more loans and the interest rate also decreases.

Mundell – Fleming Exchange Rate –  As the price level falls, there is decrease in interest rates. When the interest rate in domestic market decreases, investors invest in foreign countries where they get higher interest rates. This results in decreasing the real exchange rates because the supply of dollar increases.

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