This relationship holds true as long as “all other things remain equal.” That part is so important that economists use a Latin term to describe it: ceteris paribus. The law of demand can help us understand why things are priced the way they are. For example, retailers use the law of demand every time they offer a sale. In the short term, all other things are equal. Sales are very successful in driving demand. Shoppers respond immediately to the advertised price drop. It works especially well during massive holiday sales, such as Black Friday and Cyber Monday.
How the Law of Demand Works
There are two main ways to visualize the law of demand: the demand schedule and the demand curve. The demand schedule tells you the exact quantity that will be purchased at any given price. The demand curve plots those numbers on a chart. The quantity is on the horizontal or x-axis, and the price is on the vertical or y-axis. If the amount bought changes a lot when the price does, then it’s called elastic demand. An example of this could be something like buying ice cream. If the price rises too high for your preference, you could easily purchase a different dessert instead. If the quantity doesn’t change much when the price does, that’s called inelastic demand. An example of this is gasoline. You need to buy enough to get to work, regardless of the price. The factors that determine the level of demand are called “determinants.” These are also part of the “all other things” that need to be equal under ceteris paribus. The determinants of demand are the prices of related goods or services, income, tastes or preferences, and expectations. If the other determinants change, then consumers will buy more or less of the product even though the price remains the same. That’s called a shift in the demand curve.
The Law of Demand and the Business Cycle
Politicians and central bankers understand the law of demand very well. The Federal Reserve operates with a dual mandate to prevent inflation while reducing unemployment. During the expansion phase of the business cycle, the Fed tries to reduce demand for all goods and services by raising the price of everything. It does this with contractionary monetary policy. It raised the fed funds rate, which increases interest rates on loans and mortgages. Of course, when prices go up, so does inflation. But that’s not always a bad thing. The Fed has a 2% inflation target for the core inflation rate. The nation’s central bank wants that level of mild inflation. It sets an expectation that prices will increase by 2% a year. Demand increases because people know that things will only cost more next year. They may as well buy it now, ceteris paribus. During a recession or the contraction phase of the business cycle, policymakers have a worse problem. They’ve got to stimulate demand when workers are losing jobs and homes and have less income and wealth. Expansionary monetary policy lowers interest rates, thereby reducing the price of everything. If the recession is bad enough, it doesn’t reduce the price enough to offset the lower income. In that case, expansionary fiscal policy is needed. During periods of high unemployment, the government may extend unemployment benefits and cut taxes. As a result, the deficit increases because the government’s tax revenue falls. Once confidence and demand are restored, the deficit should shrink as tax receipts increase.
