[MUSIC] This figure illustrates the aggregate supply, aggregate demand model. The price level is represented on the vertical axis, while real domestic output, or GDP, is represented on the horizontal axis. Note that aggregate demand slopes downward, while aggregate supply slopes upward. Note also that equilibrium in the model occurs at point E, where the AS and AD curves cross. This is because at this point the price in output combination is compatible with the intentions of both buyers and sellers. Finally, note that equilibrium in this model does not necessarily have to occur at the full employment potential output GDP of Q sub c. It can also be at a recessionary level such as Q sub u where actual GDP is below potential GDP. Our task now is to discuss why this figure looks like it does and what can happen to make either of the curves shift and therefore change equilibrium in the model. Let's start with the downward sloping aggregate demand curve, which is also known as the aggregate equilibrium demand curve. Technically aggregate demand is a schedule which is graphically represented as a curve as illustrated in this figure. It shows the various amounts of real output that domestic consumers, businesses and government along with foreign buyers collectively desire to purchase at each possible price level holding other things constant. And please note this, holding other things constant, or ceteris paribus assumption because as we shall discuss shortly, it is crucial in understanding shifts in the aggregate demand curve. Now, the downward slope of the aggregate demand curve means that as the general price level falls, consumers and businesses will increase their demand for goods and services. This will happen for three reasons. First, there is a real balance or wealth effect. As the price level falls, the purchasing power of consumers increases, and they demand more goods and services. This is because the real value of money is measured by how many goods and services each dollar will buy. Accordingly, a lower price level increases the real value or purchasing power of accumulated financial assets such as savings accounts and bonds That have fixed money values. For example, a household may not buy a new car or a sailboat if the purchasing power of its assets is only $30,000. However, if there is deflation and the price level falls, the household's real purchasing power may increase to, say, $50,000. So the new purchase is more likely to be made. A second reason why the aggregate demand curve slopes downward is an interest rate effect. As the price level falls, so too do interest rates. Falling interest rates, in turn increase investment spending by businesses as well as certain kinds of consumer spending on items such as automobiles and housing. Third there is a foreign purchases, foreign trade or net export effect. As the domestic price level falls, the relative price of foreign goods increases. This reduces the demand for the now more expensive foreign imports, increases the demand for exports and thereby also increases the aggregate quantity demanded.
