Aggregate Demand

The aggregate demand-aggregate supply model is a good starting point for understanding business fluctuations. Let's begin by learning about the aggregate demand, or AD curve. The aggregate demand curve shows us all the combinations of inflation and real growth that are consistent with a specified rate of spending growth.

The easiest way to explain this is to remember from our discussions of the quantity theory of money that we can write the quantity theory in dynamic form, like this: "M" is the growth rate of the money supply. "V" is growth and velocity, or how quickly a dollar is changing hands. "P" is the growth rate of prices, and we have another name for the growth rate of prices -- that's the inflation rate, which we'll also write as pi. And "YR" is the growth rate of real GDP. So, let's just rewrite our equation very slightly as M + V is equal to inflation plus real growth. So, the left-hand side is spending growth, while the right-hand side is inflation plus real growth.

Let's give an example of how this equation works. Suppose the money supply is growing at a rate of 5% per year - M is 5%. And let's suppose that V is constant at 0%, and real growth is 0%. Then we have that 5% plus 0% is equal to inflation plus 0%. So, it follows that the inflation rate is 5%. Thus, one combination of inflation and real growth that's consistent with a spending growth rate of 5% is 5% inflation and 0% real growth. But there are lots of other combinations of inflation and real growth that are also consistent with a 5% rate of spending growth. For example, 3% real growth and 2% inflation.

Now let's do what economists always do, we'll do a graph. We're going to put inflation on the vertical axis, and real growth on the horizontal axis. And let's suppose that spending growth is 5%. An aggregate demand curve shows us all the combinations of inflation and real growth, consistent with a specified rate of spending growth. We just presented two points that are consistent with a spending growth rate of 5%, namely 5% inflation and 0% real growth, and also 2% inflation and 3% real growth. Connecting these two points we have an aggregate demand curve, a curve that shows us all the possible combinations of inflation and real growth that are consistent with a spending growth rate of 5%.

We can also interpret this AD curve in one other way. We can think about M plus V as the growth rate of spending in the economy. Or, equivalently, it's the growth rate of nominal GDP. So, the AD curve gives us all the combinations of inflation and real growth that are consistent with a specified growth rate of nominal GDP. The AD curve for a nominal GDP growth rate of 5% -- that's all the combinations of inflation and real growth that add up to 5%.

So, what's the AD curve for a nominal GDP growth rate of 7%? Right! It's all the combinations of inflation and real growth that add up to 7%. Put that on our graph. So now we can see that an increase in the growth rate of nominal GDP -- in this case an increase in the growth rate of nominal GDP from 5% to 7% -- that shifts the AD curve outwards. Similarly, a decrease in the growth rate of nominal GDP -- that shifts the AD curve inwards. Now an increase in the growth rate of nominal GDP -- that can come from either changes in M, or changes in V.

We're going to discuss how monetary and fiscal policy, respectively, can change M and V, in later videos. For now, let's just focus on the key idea: increased spending growth shifts the AD curve outwards, and decreased spending growth shifts the AD curve inwards. In the next video, we're going to combine what we know now about the AD curve with the long-run aggregate supply curve. That will give us our first model, a model of real business cycles.