Aggregate Demand and Aggregate Supply ❮ 107What tends to be the case for the demand of a microeconomic good is also the case for
AD, but for different theoretical reasons.
What Is Aggregate Demand?
A microeconomic demand curve for peaches illustrates the relationship between the quan
tity of peaches demanded and the price of peaches. When economists aggregate all microe
conomic markets to build AD, we include peaches and all other items that are domestically
produced. Aggregate demand is the inverse relationship between all spending on domestic
output and the aggregate price level of that output.
Components of AD
Demand in the macroeconomy comes from four general sources, and we have already seen
these components when we described how total production is measured in the economy.
In the previous chapter we defined real GDP as = C + I +G + (X - M).
So AD measures, for any price level, the sum of consumption spending by households,
investment spending by firms, government purchases of goods and services, and the net
exports bought by foreign consumers.
The Shape of AD
When the price of peaches rises, consumers find another microeconomic good (with a
lower relative price) to substitute for peaches, and this helps explain why the demand for
peaches is downward sloping. But if the overall price level is rising, the price of peaches,
pears, and apples might all be rising. Remember that this aggregate price level is not the
same as the price of one good relative to another. Where are the substitutes when the
“good” we are discussing is a unit of real GDP? Macroeconomists describe three general
groups of substitutes for national output:
• Goods and services produced in other nations (foreign sector substitution effect)
• Goods and services in the future (interest rate effect)
• Money and financial assets (wealth effect)
Foreign Sector Substitution Effect. When the price of United States output (as measured
by the CPI or some other price index) increases, consumers naturally begin to look for simi
lar items produced elsewhere. A Japanese computer, a German car, and a Mexican textile
all begin to look more attractive when inflation heats up in the United States. The resulting
increase in imports pushes real GDP down at a higher price level.
Interest Rate Effect. Remember that consumers have two general choices with their
disposable income: they can consume it or they can save it for future consumption. If the
aggregate price level rises, consumers might need to borrow more money for bigticket
items like autos or college tuition. When more and more households seek loans, the real
interest rate begins to rise, and this increases the cost of borrowing. Firms postpone their
investment in plant and equipment, and households postpone their consumption of more
expensive items for a future when their spending might go further and borrowing might
be more affordable. This waitandsee mentality reduces current consumption of domestic
production as the price level rises and real GDP falls.
Wealth Effect. Wealth is the value of accumulated assets like stocks, bonds, savings, and
especially cash on hand. As the aggregate price level rises, the purchasing power of wealth
and savings begins to fall. Higher prices therefore tend to reduce the quantity of domestic
output purchased.
The combination of the foreign sector substitution, interest rate, and wealth effects pre
dict a downwardsloping AD curve. For all three reasons, as the aggregate price level rises,