Shape of the AD Curve
Definition
Aggregate demand curve: the downward-sloping line showing the real output demanded at each average price level, with the average price level on the vertical axis and real output on the horizontal axis.
Reading the Curve
- The vertical axis shows the average price level and the horizontal axis shows real output.
- The curve slopes downward, so a lower price level is linked to a higher real output demanded.
Key Idea
- Three whole-economy effects explain the downward slope.
- They are the real balance, interest-rate and international-trade effects.
The Three Effects
- The real balance effect: a lower price level raises the real value of a fixed £10,000 of savings, so households feel richer and C rises.
- The interest-rate effect: a lower price level cuts the demand for money, easing interest rates, so borrowing-funded C and I rise.
- The international-trade effect: a lower domestic price level makes exports more competitive and imports dearer, so (X − M) rises.
Chain of Reasoning
- Start with a fall in the average price level.
- The three effects each raise a component of planned spending.
- Total real output demanded rises, which traces out the downward slope.
Example
- Suppose the average price level falls, so a price index moves from 102 to 100.
- A given £10,000 of cash now buys more, so households feel wealthier and consume more.
- Lower money demand eases interest rates, so investment and borrowing-funded consumption rise.
- Cheaper domestic goods raise exports and cut imports, so (X − M) rises.
- Real output demanded rises, which is the movement down along the AD curve.
How Strong Are the Effects
- The interest-rate effect is weak when the central-bank rate is already near 0%.
- The trade effect is larger for an open economy where exports and imports are a big share of GDP.
- So how steep the AD curve is depends on the size of these effects, not just their direction.
Movement, Not a Shift
- A change in the price level is a movement along the AD curve.
- A change in a component at a given price level is a shift of the whole curve.
Exam technique
- Explain the slope using the real balance, interest-rate and international-trade effects.
- Label the vertical axis average price level and the horizontal axis real output.
Common Mistake
- Do not explain the AD slope with the microeconomic law of demand.
- Do not label the axes price and quantity, as those belong to a single market.
Self review
- What are the axes of the AD curve?
- Name the three effects behind the downward slope.
- Explain the real balance effect.
- Why is a price-level change a movement along AD rather than a shift?
