If you're seeing this message, it means we're having trouble loading external resources on our website.

If you're behind a web filter, please make sure that the domains *.kastatic.org and *.kasandbox.org are unblocked.

Main content

Aggregate demand

Let's explore aggregate supply and demand, comparing and contrasting them with traditional supply and demand from microeconomics. Learn about the different axes used for plotting aggregate demand, and explains three theories behind the downward slope of the aggregate demand curve: the wealth effect, the interest rate effect, and the foreign trade effect. Created by Sal Khan.

Want to join the conversation?

  • leaf green style avatar for user Andrew
    Don't all three theories say that deflation is good?
    (31 votes)
    Default Khan Academy avatar avatar for user
    • blobby green style avatar for user zaclim1
      Sal said that this is one way of explaining economics. The graph is explaining that assuming ceteris paribus (all things remaining the same - employment, business confidence etc), a drop in prices will result in more goods being consumed, hence an increase in GDP. However i think this graph is a bit confusing when applied to some of the concepts we have learned previously. We seem to equate deflation with a depressing economy and a moderate inflation with a growing economy. We need to understand that real purchasing power also exist during an inflationary economy
      (6 votes)
  • female robot ada style avatar for user Tomáš Protivínský
    I've realized that the savings effects (starting about ) is not clear to me. The savings effect means that prices go down, therefore people buy less stuff and save more money. But according to microeconomics model, people should based their decision, how much money they spend on goods and how much they save, on the benefits of each option. When prices go down, spending should give them more benefit (comparing to the savings) and they should spend more then before, shouldn't they?
    (29 votes)
    Default Khan Academy avatar avatar for user
    • duskpin tree style avatar for user Jessi Reyna
      How Sal explained the savings effect was that when prices dropped on goods and services, people were able to buy more goods and services, and yet save more. That's on of the reasons the aggregate demand curve is downward sloping.

      When the price is low, there is more output because there is more consumption. But just because prices dropped doesn't mean that people spend more, it just means that the money that people currently have has more spending power, whereas when it was that one dollar yesterday could buy one bag of chips, today one dollar can buy two bags of chips.
      (48 votes)
  • blobby green style avatar for user Charles Grenier
    Is there a video that explain why you get better interest rate by converting your money, I'm not sure I understand that concept... it's in the debut of the third concept : foreign exchange. Thx
    (9 votes)
    Default Khan Academy avatar avatar for user
  • leaf red style avatar for user Tanushree
    When price level goes down, is more GDP produced or more GDP demanded? Also, if exports increase, doesn't the aggregate demand curve shift to the right?
    (7 votes)
    Default Khan Academy avatar avatar for user
  • leaf green style avatar for user FinallyGoodAtMath
    Regarding the Foreign Exchange Effect, does the dollar weakening relative to other currencies affect the price of domestic goods for people using the dollar?
    (3 votes)
    Default Khan Academy avatar avatar for user
    • leaf green style avatar for user David Baunsgaard
      There are a couple of things that would happen. As the dollar weakens, price of imports go up, meaning people are more likely to spend their money inside the US. To foreigners, the relative price of US goods will drop, making them more likely to purchase US goods -> exports increase. Thus the US aggregate demand will increase, causing US prices and GDP to increase.
      Also, the relative price of certain imported goods, used for production (oil for example) would increase, again causing prices within the US to increase.
      (10 votes)
  • female robot ada style avatar for user Tomáš Protivínský
    Does the model with aggregate demand work just in short term period or also in long term? Because I expect that in long term period, if the prices go up, also the wages should go up - and therefore there shouldn't be any of the three effects...
    (7 votes)
    Default Khan Academy avatar avatar for user
    • mr pants teal style avatar for user Wrath Of Academy
      In "real" terms (ie, inflation-adjusted) this way of thinking about the graph would work over the long term. Keep in mind this graph is purely imaginary to help you think about the economy - it doesn't really exist.

      You can imagine though that suddenly someone invents a way to build a fusion electricity generator for a few bucks. This would permanently decrease the cost of energy to almost nothing. It would therefore permanently increase the real productivity of the economy, because people that used to work building power plants are now freed up to build computers or furniture or whatever else consumers want.
      (3 votes)
  • leaf blue style avatar for user Tesh Hath
    At , Sal says that the interest rates are down (meaning there is more money that can be easily be lent out). Are there two different types of interest rates being referred to here? It seems that the first interest rate is the one relating to how much someone would have to pay as interest on a loan they received (perhaps as an addition to their monthly payoffs of said loan). The second seems to be how much someone gains on their savings if kept in a savings account at a bank (which would be incentive for someone to exchange their currency). Any help would be appreciated!
    (3 votes)
    Default Khan Academy avatar avatar for user
    • male robot hal style avatar for user Andrew M
      They are different rates but they tend to move together.
      If people say "interest rates are down", typically they are referring to a benchmark interest rate, like the risk-free rate on a government bond. When the risk free rate moves down, other rates tend to fall with it. Some fall right along with it, others are more sticky. It's like when the price of oil goes down. Some gas stations lower their price right away, others don't. Interest rates are just prices. They are the price of using someone else's money for a little while
      (3 votes)
  • blobby green style avatar for user Billy DeMarzo-Sanchez
    You said that ceteris paribus means all things equal, the aggregate demand curve goes down. Does that still mean wages are the same? Because technically aren't prices what determine wages. If all things equal includes wages, then what is the point of the aggregate demand curve? When would prices fall ( or rise) but wages would not? And why would that happen? Thank you for your help!
    (3 votes)
    Default Khan Academy avatar avatar for user
    • old spice man green style avatar for user Jason
      I will take a shot at this (I am not sure that I know for sure).... I think its speaking in theory -- so, in theory if all prices droped and everything else stays the same -- this would happen.
      Over the long run, if prices remain low, the products that have a large percantage of cost related labor would cause wages to fall (or replace by automation).
      (2 votes)
  • leaf green style avatar for user laperla.creepy
    Regarding foreign exchange theory: How does having less purchasing power of your country's currency translate into increased real GDP?
    (2 votes)
    Default Khan Academy avatar avatar for user
  • leaf green style avatar for user greenleaf95
    It doesn't make so much sense to me.
    Lets say that one day you wake up, and prices went down half the price, that means you only need to work half as much as before causing GDP to decrease.
    (1 vote)
    Default Khan Academy avatar avatar for user

Video transcript

In this and the next few videos we're going to be studying something called "aggregate supply" and "aggregate demand." Actually, we're going to start with aggregate demand and then start talking about aggregate supply. We're going to think about aggregate demand and aggregate, I'll rewrite the word, aggregate supply. What I really want to emphasize in this video is in a lot of ways, it's going to look similar to traditional supply and demand, but I want to emphasize that there's a very big difference between aggregate demand and traditional demand in a microeconomic context. Aggregate supply in a macroeconomic context and just regular supply in a microeconomic context. To think about that, let's go to the micro version. These are macroeconomics so we're looking at economy as a whole. These are macro ideas. To make that comparison, let's revisit the micro-, the microeconomics ideas of supply and demand. To do that, we can focus on a particular market. Maybe it's the market for candy bars, so this is the market for candy bars. We've seen this many, many, many times, this is most of what we were doing when we were studying microeconomics. On the vertical axis, we would plot the price per unit from the candy bar and the horizontal axis you would have the quantity bought or sold in the given amount of time. We saw that the demand curve tended to be downward sloping, it would look something like that. There was multiple ways to interpret this. One way to interpret this at a high price, people would say, "Why should I buy this candy bar? I could buy other things with that money that would make me just as happy or happier." So they would purchase a low quantity of it. At a low price, this is a low price right over here, people say, "This is a pretty good deal. I can get candy bars, they're so cheap, I can buy a bunch of them. Instead of buying other things, instead of buying lollipops and ice cream, I'll buy candy bars," then they'll buy a high quantity of it. So that's one way to interpret it. The other way to interpret it was as essentially as a marginal benefit curve. That very first few units of candy bars to get produced, there's someone there who just loves candy bars so much there's a high willingness to pay for it. There's a high benefit for those first few units. As you have more and more units, the incremental benefit to the market gets less and less. You can view as they are people who still like candy bars, but not as much as the people who bought those first few units. That is why you have a downward sloping curve. When we think about aggregate demand, it's going to look very similar, but the idea is a good bit different. I'll do it in a different color to show that it's different. Now we're in the macro version. We're talking about aggregate demand. Aggregate demand. The first thing to realize is we're talking about aggregate demand. We're going to be thinking about the economy as a whole. We're not just thinking about the market for just one good or service. In aggregate demand, what we do is we plot on the horizontal axis, not quantity, not just the quantity bought or sold of one good or service in an amount of time, we plot the actual production of the economy in a given period of time. We've already studied that. The actual production of the economy in a given period of time is real GDP. We plot, on this axis, real GDP, so it's really how much are we producing? I guess there is an analogy to quantity, it's kind of the quantity of the productivity of the economy. In this axis right over here, we plot price level. This is prices. This isn't prices for one good or service, this isn't just a price for candy bars, this is the general level of prices in the economy. Maybe you're saying it's a weighted average or however you want to measure it, some way of measuring the level of prices and economy. What we will see is this is a downward sloping curve. It does look like this. It will look something like this or we can assume, we actually don't know whether it definitely looks like that, but economists will tell you it looks like that based on certain theories. They like it this way because it starts to explain, based on their models, and you can kind of separate out the emotional aspects of economics, it is one way of potentially explaining economic cycles, although if you know from the last video I'm actually a stronger believer in the emotional aspects of it. But it will be downward sloping. It will be downward sloping like this. Once again, this is one product, goods or service right over here. This is the economy as a whole. This is just a general level of prices. This is the actual productivity of the economy. This is saying, and it's a little unintuitive at first, that if prices are high, it's seldom this extreme, it's not like the GDP would go to zero, but we'll just assume it's simplified like this ... Maybe I'll draw it with something like this ... Maybe I'll have it something like, maybe draw it something like that so I don't have to make the extreme statement that if prices are at some level, that there will be no GDP. Generally saying if prices are high, GDP will contract and remember, ceteris paribus, all other things equal, if prices are low, GDP will expand. It's happening for completely different reasons than this downward sloping. This downward sloping is essentially a substitution effect. When prices are high, people say, "I don't need to buy candy bars. I can go buy ice cream or Slurpees or Slushees or something else that makes me happy," or and when prices are low, they say, "Let me substitute candy bars for other things because I'm getting a good deal on candy bars." Over here that is not what is happening. What's happening here, and there's a couple of theories why economists will justify a downward sloping aggregate demand curve, let me make this clear, this is aggregate demand. This is essentially saying how much productivity there will be in the economy as a function of price levels in the economy. This is aggregate demand ... And this is just demand right over here. There's three major theories why economists believe that there is a downward sloping aggregate demand curve. The first is called the "wealth effect." Let me write these down. The first is called the "wealth effect." The wealth effect is just saying, and once again, it's a little nonintuitive, because in my mind when I start saying prices have gone down, I start saying, "Prices have gone down, wages have gone down, maybe profits have gone down, and then people will get less optimistic, the economy will shrink." That's not what we're saying in this chart right over here. Remember, ceteris paribus ... All other things equal. We're assuming over here only, so if we take this scenario right over here, we're assuming only prices have gone down. Everything else in the economy is equal. Employment has not changed. Profits have not changed. People's optimism has not changed. The only thing that changes is people wake up one day and everything in the economy is half the price it was before. People have the same savings. They have the same amount of money in their wallet. If that happens, all things equal, now they say, "With the same amount of money that I have in my wallet, I can now buy more. I feel wealthier." That's the wealth effect. They will say, "I will go and demand more goods and services because with what I have in my pocket, I can go buy more things." Likewise, if for whatever reason people woke up the next morning ... Remember, all other things equal, if the price of everything were to double, they say, "Oh my God! I can't buy anything anymore. Everything's too expensive. I have to buy less of it. I'm going to demand fewer goods and service." The wealth effect is one theory that would explain, all other things equal, why you would have a downward sloping aggregate demand curve. The other one is related to interest rates. I would call it savings and interest rate effect. Interest rate effect. You can imagine, if before this bar represented the total amount of money someone had in their pockets, and this is how much they needed to spend on goods and services in order to have a nice, happy, productive life, this is originally what they were going to save, now all of a sudden, now if all of a sudden if things get a lot cheaper, they don't have to spend this much on goods and services. They could spend less on goods and services. Maybe if things got a lot cheaper, they could spend less on goods and services. Now they could spend maybe this amount on goods and services, and they could save much more. Right over here ... Remember, all other things equal, if everyone woke up tomorrow and things were just half priced, people would be able to spend less on the things they need, and they would be able to save a lot more money. We've seen before, savings, when people save money, it just goes into the financial system. You save it, you put it into the bank, and it just gets lent out to other people. So when you have increase in savings, all other things equal, when prices goes down, all other things equal, then savings go up which means that the supply of money to be lent, supply of lenders or money to be lent, money lending goes up. We saw that in a previous video. If you increase the supply of money that can be lent, the price of borrowing the money will go down. Another way to think about it, interest rates. Interest rates will go down. When interest rates go down, it becomes cheaper, you have to spend less interest to borrow money and make investments. Borrow money, build a house. Borrow money, build a factory. Borrow money, do whatever ... buy inventory. Interest rates go down, that stimulates investment, that stimulates investment, which once again, would cause the economy to expand. You would have more goods and services being produced. Likewise, if you went the other way, if prices went up, this is a situation where prices went down. if prices went up, now all of a sudden, people have to spend more of their money. More of their money on the things that they maybe think that they need to survive and be happy. There will be less savings. If there's less savings, there's less money to be lent. There will be higher interest rates and there will be less investment, so the economy will contract. So real GDP ... And remember, when I say GDP here, maybe I'll call it real GDP, real GDP would go down. This is real GDP would go up. The third theory of why ... or the third justification because economists like to have this downward sloping curve so that they can justify, and we'll see how aggregate supply and demand can cause business cycles, the third effect is essentially, I'll call it a foreign exchange effect. A foreign exchange effect. Foreign exchange. Based on the line of reasoning, so let's say a situation once again where prices went down, based on their line of reasoning and justification, we said if prices go down, then interest rates go down because there's more money to be lent in that economy in that currency. If interest rates go down, investors might say, "I only get low interest in my country. Why don't I convert my money into other currencies where I can get higher interest rates?" So if interest rates go down, people convert out of the currency. Convert out of the currency. So maybe before, if we're talking about America and maybe the interest rates are really low in the US and interest rates are higher in the UK, maybe because prices didn't go down there as much, people say, "I'm going to convert my money from dollars to pound sterling." When they do that, they will essentially, because once again, if people are converting from ... I've gone in-depth on some of the videos on foreign exchange, if people are converting from dollars to pounds, that means that there's a larger supply of dollars and more demand for pounds. The price of the dollar relative to the pound will go down. Essentially, the dollar will weaken. The dollar will weaken relative to other currencies. If the dollar weakens relative to the other currency, this is a little confusing, I go into more depth into this when I talk about currency exchange, if the dollar weakens relative to other currencies, then American goods and services are going to appear to be cheaper to people in England. For example, if I offer to make a car in America for $10,000, maybe $10,000 before all of this happened, translates into 5,000 pounds, but now the dollar has weakened. Now $10,000 is going to translate into 4,000 pounds. Foreign consumers will say, "Wow, American cars just got cheaper when we view it in our own currency." More and more of them are going to want to buy American things so America will export more. Once again, if there's more demand for American goods and services, the GDP will expand. This is related to low interest rates driving people to take currency out or exchange out of the currency we're talking about, which will make that currency cheaper, which will make its goods and services cheaper to the rest of the world, which it will essentially once again, make net exports increase. You really could just cut to the chase and say if the price level all of a sudden in US dollars just got cheaper, people say there's deals to be had in the US, and once again, net exports would increase. Once again, when you have low price level, you could have GDP expanding. Obviously if the prices were to increase, the opposite dynamic might occur.