Aggregate Demand

We now have the basics of a complete theory of aggregate demand -- that is, a theory of why the aggregate demand for real GDP drops as the price level rises, or, in still other words, why the Pigou Curve is downward sloping.

Talk about aggregate demand, we recall, is reasoning by analogy. The analogy is to the demand for particular goods and services in microeconomics. The microeconomic demand for wheat (for example) is the relationship between the price of wheat and the quantity of wheat demanded, and tells us, for each price, how much wheat will be demanded. It is an inverse relationship. So the analogy suggests that the Pigou Curve would be an inverse relationship between the average price level and the quantity of RGDP demanded. However, our first approximation to a Pigou Curve, in the Simple Keynesian Model, was not an inverse relation. Instead, it was vertical. To make sense of the analogy, we pose the question: why would the relation between the average price level and the RGDP demanded be an inverse relation? Why would an increase in the price level result in a decrease in the quantity of RGDP demanded?

We now have an answer:

An increase in the price level reduces the purchasing power of a given money supply
The lower real money balances reduces the price of bonds, increasing the interest rate
The increase in the interest rate reduces investment
The reduction in investment reduces real GDP demanded through a multiplier effect.

This is a rather long chain of cause-and effect relationships, as one change causes another. We might call it the Aggregate Demand Chain. We have looked at each of the links, as we worked toward this point; now we can look at the "chain" as a whole.

Let's look at the chain in schematic terms:

Aggregate Demand Example