Chapter 10
Gesamtwirtschaftliche Nachfrage GN: (Aggregate Demand: AD)

The aggregate demand Y D in an open economy is assembled by the following components:

Y D = C + I + G + NX,


C = the aggregated household consumption

I = the gross investment of enterprises

G = the government demand and

NX = the foreign net demand (exports – imports).

The aggregate demand curve represents the quantity of all goods and services that are in demand in an economy at different price levels. The graphic form of the AS-AD model, which shows the dependence of the aggregate demand on the change of price level, is derived from the IS-LM model. For this purpose, we look at the goods market

IS : Y = C(Y T) + I(Y,i) + G + NX

and the money market:

LM : M P = Y L(i).

The combination of the two equations shows a negative correlation between the price level and the real national product. The negative slope of the curve can be explained mainly by three effects: (1) the Keynesian interest rate effect, (2) the Pigou asset effect and (3) the Mundell-Fleming exchange rate effect. The interest effect is probably the most obvious and important effect, and can be read directly from the equations.

Keynes interest rate effect
John Maynard Keynes (1883-1946) introduced the term transaction cash to illustrate the effect of a price level change. A rising price level causes households to increase their transaction cash, since more money is needed to pay for the same quantity of goods. Therefore, households will liquidate part of their interest-bearing assets. This leads to decreasing bond prices and c.p. rising interest rates (money market). The higher interest rate in turn reduces the incentives for companies to invest. This ultimately leads to lower aggregate demand (goods market). In case of a decline in the price level, the analogous analysis ends with an increase in demand.
Pigou asset effect
Arthur Pigou considers the subjective feelings of the asset owners. For a given money supply M, an increase in the price level leads to lower real cash balances of private households. Consumers feel poorer and reduce their spending. The aggregate demand decreases. Conversely, a price level reduction increases real cash balances and leads to an increase in private consumption and thus to higher aggregate demand. For example, the amount of money in a wallet is clearly defined in nominal terms. When prices fall, the quantity of goods that can be purchased with this money increases. (The budget line shifts to the right.) The increased purchasing potential causes people to feel richer and buy more goods.
Mundell-Fleming exchange rate effect
In the Mundell-Fleming model, the change in the interest rate induced by a change in the price level leads to effects on the international markets, which then influence aggregate demand. The Mundell-Fleming exchange rate effect is based on the following chain of effects: falling interest rates at home increase the relative attractiveness of investments abroad and thus lead to an outflow of capital. On the foreign exchange market, the supply of domestic currency and the demand for foreign currency increase and lead to a depreciation of the domestic currency. The relative competitiveness of domestic enterprises in comparison to foreign enterprises improves. Domestic products become cheaper abroad and foreign products become more expensive on the domestic market. Exports rise and imports fall. In general, net exports and, thus also, aggregate demand increase. Conversely, a rise in interest rates leads to capital inflows and an appreciation of the domestic currency. Exported goods become more expensive abroad and exports fall, while imports become cheaper and increase. Net exports and aggregate demand decrease.
Shift of the AD curve: Demand policy and demand shocks, monetary policy and fiscal policy
The aggregate demand curve illustrates the change of the quantity demanded depending on the price level, i.e. a change in the price level leads to a movement along this curve. A change in other variables, e.g. the money supply or government demand, leads to a shift of the demand curve, since the quantity of demanded goods changes at every price level. Besides monetary and fiscal policy, exogenous shocks can also shift the AD-curve. Examples of shocks are crisis-induced changes in behavior, war, a change in foreign demand or booming asset markets. The graphic below, with the corresponding sliders, illustrates the reactions.

Crisis-induced changes in behavior (saving) and the reduction of foreign demand (e.g. economic crisis abroad) lead to a shift to the left of the AD-curve, since at any given price level demand is reduced. War (arms expenditure) and stock market bubbles (growing wealth) lead to a shift to the right due to increasing demand. An expansive monetary policy (expansion of the money supply and reduction of interest rates) leads via the interest rate-, wealth- and exchange rate- effect to an increased demand, i.e. a shift to the right. A restrictive monetary policy c.p. leads to a shift to the left.

An expansive fiscal policy (tax cuts, increases in government spending) leads indirectly via higher private consumption (citizens have a higher disposable income) or directly to a higher aggregate demand, i.e. a shift to the right.

(c) by Christian Bauer
Prof. Dr. Christian Bauer
Chair of monetary economics
Trier University
D-54296 Trier
Tel.: +49 (0)651/201-2743