Consumer Spending Habits: Aggregate Demand

Aggregate Demand The demand for goods and services is an important influence on the performance of the economy. Demand in the aggregate depends on the willingness and ability of consumers, business firms, and governments to purchase the goods and services produced nationally and available for sale in domestic and foreign markets. The amount of final products that will be demanded in any given year depends on a variety of factors including the price level, consumer confidence, wealth, and the availability of credit. In analyzing the overall demand for final products in the economy we first isolate the relationship between the amount that will be demanded and the general level of prices for products holding all other influences on demand fixed. The quantity of final products (measured as real GNP) that buyers will purchase at a given price level is called the aggregate quantity demanded. Aggregate demand is a relationship between aggregate quantity demanded and the economy's price level. In macroeconomics we depict this relationship using an aggregate demand curve, a graph that shows how aggregate quantity demanded varies with the price level for an economy. A downward sloping aggregate demand curve implies that the lower the price level the greater the aggregate quantity de-manded, other things being equal. The graph in Box 1 shows an aggregate demand curve prevailing for a given year. The vertical axis measures the price level for the aggregate of final goods and services included in real GNP. The horizontal axis measures the quantity of final products demanded measured in base year (1982) dollars, representing the quantity of aggregate production that will be demanded for the year at each possible price level. Although the aggregate demand curve might look like a market demand curve, it's really quite different. It describes a relationship between an index of prices and an aggregate of final products demanded in a nation instead of a relationship between the price and quantity of a single good. For example, when you move down an aggregate demand curve, there is an increase in an aggregate of goods and services demanded in the nation. When the price level falls, it means that the cost of purchasing an aggregate (or "market basket") of many products falls. It's possible that some individual prices may actually rise when the price level itself falls, and vice versa. Because changes in real GNP mean changes in input use in the nation, income earned in the nation also changes when you move along an aggregate demand curve. Therefore income is not held constant as you move along an aggregate demand curve even though it is when you move along the market demand curve for a single product. The downward-sloping aggregate demand curve means that an increase in the price level will decrease the willingness and ability of at least some buyers to purchase the products included in real GNP. The reasons for the downward slope of an aggregate demand curve are much more complex than those that explain downward-sloping market demand curves for a single product. Three basic reasons for the inverse relationship between the aggregate quantity of real GNP demanded and the price level are: 1. The real wealth effect: higher prices can decrease real wealth in a nation and reduce consumer spending on final products. The purchasing power of accumulated savings denominated in fixed dollar amounts declines when the price level goes up. For example, suppose you have $100 in cash in a cookie jar in your apartment. If the price level rises, the real value of this currency falls. The reduction in purchasing power associated with the rise in the price level will make you less wealthy and can decrease your willingness and ability to purchase final goods and services. The aggregate reduction in wealth caused by an increase in the price level is likely to decrease the willingness and ability of all consumers to purchase currently produced final products during the year. A higher price can also increase saving. If savers have specific goals such as accumulating enough funds to make a down payment on a house or to finance their children's college education, an increase in the price level can induce them to save more of their current income for those purposes. When the price level rises, they must accumulate more dollars to achieve the same objective. For example, if the goal is to save enough to pay a child's college tuition costs in the future, an increase in the price level that also increases tuition will mean that more dollars now must be saved to achieve the goal. As the desire to save increases as a result of the higher price level, consumer purchases in the current year decrease, resulting in a decrease in the aggregate quantity demanded. 2. The real interest rate effect: a higher price level can increase interest rates, making credit more expensive and reducing the quantity of investment goods demanded. The ability of business firms and households to purchase goods and services produced also depends on the cost of credit, which is measured by the real interest rate. Naturally, at a higher price level the dollar amount of credit necessary to purchase any given quantity of goods and services also increases. The increased demand for credit resulting from the higher price level puts upward pressure on real interest rates. As real interest rates rise, business firms cut back on their purchase of investment goods and households cut back their spending. These actions decrease the aggregate quantity of goods and services demanded. 3. The foreign trade effect: a higher price level reduces foreign demand for U.S. exports and increases domestic demand for imports. Because the higher domestic price level implies that U.S. goods become more expensive relative to foreign goods, consumers in the United States tend to substitute imported goods for domestic goods. For example, rapid increases in the price level over the year mean an increase in the price of U.S. products such as domestically produced cars. Assuming the increase in the price level in the United States has little effect on the dollar prices Korean sellers are willing to accept for cars they export to the United States, there will be a decrease in the quantity of U.S. cars demanded and an increase in the demand for Korean-made imported cars. The increase in the price of U.S. items also decreases the quantity of U.S. exports demanded, other things being equal. The net effect of the increase in the price level is therefore a decline in the demand for the final products of U.S. firms in foreign markets and a further decline in the quantity of final products of U.S. firms demanded in domestic markets as buyers substitute foreign goods for domestic goods. Both the increase in U.S. demand for foreign products and the decrease in demand for U.S. products abroad contribute to a decline in the aggregate quantity of U.S. final products demanded during the year.'