Aggregate demand (AD) is the quantity of goods and services that households, businesses, and foreign customers want to buy at any given level of prices.

The IS Curve

GDP = C + I + G + (X - M)

• Consumption (C) is a function of disposable income. Consumption increases when income(Y) increases and/or taxes decrease.
  The marginal propensity to consume (MPC) is defined as additional current consumption divided by additional current disposable income. The marginal propensity to save (MPS) = 1 - MPC.

• Investment spending depends on the interest rate (i) and output/income level.

• Government purchases are assumed to be unrelated to both interest rates (i) and income (Y). Although tax policy is also considered an exogeneous variable, the actual taxes collected depend on income (Y) and are therefore endogenous. The government's deficit (G - T) increases as income decreases and vice versa.

• Net exports (X - M) depends on relative income and prices between the domestic country and the rest of the world.

We can also derive the following equation, which shows that domestic saving has three uses: investment, government deficits, and trade surplus:

S = I + (G - T) + (X - M), where S is domestic saving.

If we combine these relationships together we can derive the IS curve: the combination of GDP (Y) and the real interest rate (i) such that aggregate income/output equals planned expenditures.

Note that there is an inverse relationship between income and the real interest rate. For example, when interest rates are high, investment falls and therefore Y must fall as well.

Note that changes in Y caused by changes in i are reflected as movements along the IS curve. On the other hand, changes in Y that are brought about by factors other than interest rates will cause Y to change, regardless of the level of interest rates in the economy. For example, changes in government purchases will not change the slope but will change the intercepts; in other words, they will cause the IS curve to shift.

The LM Curve

The IS curve depicts combinations of interest rates and output that clears markets for goods and services. The IS curve by itself does not pin down the interest rate that prevails in the economy. In order to do so, we look at the money market. The LM curve summarizes all the combinations of income and interest rates that equate money demand and money supply.

The quantity theory of money: MV = PY, where V is the velocity of money.

• When interest rates (i) are high, the demand for money is low because money pays no interest; the opportunity cost of holding money rises.
• When Y is high, the demand for money is high; richer people buy more goods and are likely to hold more money.
• When P is hig,h the demand for money is high because we need more money to buy goods.

When the money market is in equilibrium, money supply = money demand. The LM curve summarizes all the combinations of income and interest rates that equate money demand and money supply. It is an upward-sloping relationship between i and Y.

Intuitively, we can explain the upward-sloping LM curve as follows: Let's consider some combination of income and interest rates that equates money demand with the money supply set by the Fed. Now suppose there is an increase in income. The increase in income causes the demand for money to increase. However, money supply is unaffected by the increase in income. The only way that money demand and money supply can be equal again is if interest rates also increase to reduce money demand.

The Aggregate Demand Curve

Combining the IS and LM relationships yields the aggregate demand curve, which depicts the inverse relationship between the price level and real income/output, assuming a constant money supply.

For example, a reduction in the price level will:

• Increase the wealth of people holding the fixed quantity of money.
• Reduce the real rate of interest.
• Make domestically produced goods cheaper than those produced abroad.

All these factors will lead to an increase in the quantity of goods and services demanded at the lower price level (movement along the curve).

Practice Question 1

In the short run, an increase in saving might ______

A. raise aggregate demand by increasing consumption.
B. reduce aggregate demand by reducing investment.
C. reduce aggregate demand by reducing consumption.

Correct Answer: C

Aggregate demand will fall if the increase in saving reduces consumption more than it increases investment.

Practice Question 2

During the Vietnam War, President Lyndon Johnson increased government expenditures while raising taxes. As a result, ______

A. the AD curve likely shifted to the left.
B. the AD curve likely shifted to the right.
C. what happened to the AD curve is unclear.

Correct Answer: C

An increase in government expenditures shifts the AD curve to the right while an increase in taxes shifts it to the left. Depending on the relative shifts, the AD curve could shift to the left, to the right, or not at all.

Practice Question 3

The relationship between the price level and the quantity of real GDP demanded is called ______.

A. augmented demand
B. consumer demand
C. aggregate demand
D. market demand
E. long-run market demand

Correct Answer: C

This is the definition of aggregate demand.

Practice Question 4

Which of the following is (are) NOT a reason why the aggregate demand curve is downward-sloping?

I. When the price level rises, the real wealth of consumers decreases, and thus consumers buy less.
II. When the price level rises, interest rates tend to rise, decreasing the quantity of investment.
III. When the price level rises, consumers will substitute other less-expensive goods, and the quantity demanded will fall.
IV. When the price level rises, domestic goods become more expensive relative to foreign goods, and thus exports fall and imports rise.

Correct Answer: III only

Unlike demand in a single market, aggregate demand is not downward-sloping due to substitution effects. Aggregate demand is a relationship between average prices and ALL output, and thus this sort of substitution effect is not possible.