MODULE 17- Aggregate Demand TO BE OR NOT TO BE GDP

Memory Jog Module 17 deals with why business activity fluctuates. A way to explain changes in output/unemployment/price level. Go Back to GDP C+I+G+(X-M)

Let Build a Model C+I+G+(X-M) The components of GDP determine the value of total expenditures. Consumers, Business Capital Investment, Government, Foreign Markets make these spending decisions.

PRICE LEVEL (PL) The average price of ALL goods and services- a/k/a final products – a/k/a outputs - in the economy

PRICE LEVEL (PL) The economy’s overall price level (PL) can be viewed in two ways: 1. the price of a basket of goods and services (when the PL rises, people have to pay more for the G/Ss) 2. as a measure of the value of money (a rise in the PL means a lower value of money because each dollar in your pocket now buys a smaller quantity of G/Ss)

Remember Two issues must be answered. 1.What determines the total amount that individuals, firms, governments, and foreigners want to spend? 2.What determines whether this spending will result in a higher output of goods/services (quantity) or higher prices (inflation)? Answered by developing? Aggregate Demand and Aggregate Supply

Let Us Build a Graph! Aggregate Demand (AD)- TOTAL of all planned expenditures for the entire economy. Aggregate Supply (AS)- TOTAL of all planned production for the entire nation.

Aggregate Demand (AD) Aggregate Demand (AD) Curve A curve showing planned purchase rates for all G/Ss in the economy at various PLs, all other things held constant AD Curve is a shorthand way of illustrating the components of GDP.

Aggregate Demand (AD) C+I+G+(X-M) Furthermore, AD Curve gives the total amount of Real Domestic Income (RDI) that will be purchased at each price level. RDI = RGDP Remember Circular Flow.

The AD Curve 10 AD Price Level/ GDP Deflator Real GDP per Year ($ trillions) A As the price level rises, real GDP demanded declines B C

The (AD) Curve 11 AD Price Level/GDP Deflator Real GDP per Year ($ trillions) C As the price level falls, real GDP demanded increases B A

Question- Why might the Law of Demand and the reasons for the downward slope of the demand curve not be applicable with aggregate demand. Law of Demand (one G/S) states P QD P

M I C R O to M A R C O Now dealing with the entire macroeconomy. PL is the average price of all G/Ss including wages. Remember, when the PL for G/Ss increased the consumer would substitute other G/Ss. Now there are no substitutes. The Law of Demand still applies and the AD curve is still downward sloping but for different reasons.

Downward Slope of the AD Curve— Reasons WHY Plenty of a/k/a When the PL Changes The Direct Effect: The Real-Balance Effect (Wealth Effect) The Indirect Effect: The Interest Rate Effect The Net Export Effect: The Open Economy Effect: The Substitution of Foreign Goods

The AD Effect—Real-Balance The Real-Balance Effect The change in the real value (purchasing power) of money balances when the PL changes. While your nominal cash value stays the same, any change in the PL will cause a change in the real value (purchasing power) of cash balances.

The AD Effect—Interest Rate The Interest Rate Effect- Change in the PL indirectly effects the interest rate. 1.When PL increases, constantly replace lost purchasing power. 2.Greater demand for money causes the nominal interest rate to increase. 3.As interest rates rise this makes borrowing less attractive thus reducing the quantity of AD. PL increase PL decrease works in the opposite direction.

REMINDER NOMINAL INTEREST = REAL INTEREST + EXPECTED INFLATION If inflation expectations gradually fall, nominal interest rates should also gradually fall Lower interest rates will increase spending, thus increasing RGDP along the AD curve

The AD Effect—Open Economy The Open Economy Effect (the substitution of foreign goods) Higher PLs result in foreigners’ desiring to buy fewer American- made goods while Americans desire more foreign-made goods (i.e. net exports fall) This decline in net exports causes a decrease in the quantity of AD.

Review- A Change in the PL Direct Effect/Real Balance Effect/Wealth Effect If PLPurchasing Power If PL Rate of Consumption Quantity AD Purchasing Power Rate of Consumption Quantity AD

Review- A Change in the PL Indirect Effect/ Interest Rate Effect If PL Demand for Money Nominal Interest Rate Consumption/ Investment Quantity AD Demand for Money Nominal Interest Rate Consumption/ Investment Quantity AD If PL

Review- A Change in the PL Open-Economy Effect (substitution of foreign goods) If PL U.S. goods/services more expensive than foreign. Substitute foreign goods for U.S. goods/services. Quantity AD If PL U.S. goods/services cheaper than foreign. More U.S. goods/services purchased than foreign. Quantity AD

Review- A Change in the PL Remember with any of these three reasons, it is a change in the PL. moving up/down the AD curve (movement along the AD curve)

Shift HAPPENS WITH the AD Curve The shifts will cause changes in the quantity demanded at any given PL. An INCREASE in AD means a shift of the AD curve to the RIGHT A rightward shift occurs when the quantity of aggregate output demanded increases at any given aggregate PL A DECREASE in AD means that the AD curve shifts to the LEFT A leftward shift implies that the quantity of aggregate output demanded falls at any given aggregate PL

Non- Price Determinants of AD Any non-PL change that effects any component of: C + I + G + (X-M) will cause a shift in the AD curve.

SHIFT HAPPENS to the RIGHT: Non- Price Determinants of AD Any non-PL change that increases aggregate spending (on domestic goods) shifts AD to the right. 1.A drop in the foreign exchange value of the dollar 2.Increased security about jobs and future income 3.Improvements in economic conditions in other countries 4.A reduction in real interest rates (nominal interest rates corrected for inflation) not due to price level changes 5.Tax decreases (Fiscal Policy) 6.An increase in the amount of money in circulation (Monetary Policy)

Shift Happens RIGHT to the AD Curve AD GDP Deflator Real GDP per Year ($ trillions) AD 1 Increase in Aggregate Demand

SHIFT HAPPENS to the LEFT: Non- Price Determinants of AD Any non-price-level change that decreases aggregate spending (on domestic goods) shifts AD to the left. 1.A rise in the foreign exchange value of the dollar 2.Decreased security about jobs and future income 3.Declines in economic conditions in other countries 4.A rise in real interest rates (nominal interest rates corrected for inflation) not due to price level changes 5.Tax increases (Fiscal Policy) 6.An decrease in the amount of money in circulation (Monetary Policy)

Shifts Happens LEFT to the AD Curve AD GDP Deflator Real GDP per Year ($ trillions) AD 1 Decrease in Aggregate Demand

SUMMARY-- 1. Changes in Expectations When consumers and firms are more optimistic about their future economic prospects, they will increase consumption and investment spending. This shifts AD to the right. 2. Changes in Wealth When the value of accumulated household assets goes up, consumers respond by increasing current consumption. This is one reason why a weak stock market or real estate market has a negative ripple effect in the economy by shifting AD to the left. 3. Size of the Existing Stock of Physical Capital Firms plan to invest in physical capital when the stock is being depleted or is insufficient to meet demand for their products. If firms have plenty of physical capital already, investment spending will slow down.

SUMMARY—World Economy The foreign exchange rate and foreign income influence AD. Foreign exchange rate is the amount of foreign currency you can buy with a U.S. dollar. Other things remaining the same, a rise in the foreign exchange rate decreases AD. An increase in foreign income increases U.S. exports and increases U.S. AD.

SUMMARY—Government Policies and AD Think how the government can affect AD Government can have a powerful influence on AD and in some circumstances, this influence can be used to improve economic performance. The two main ways the government can influence the AD are through: fiscal policy (Congress and President) monetary policy (Federal Reserve System)

SUMMARY—Fiscal Policy Congress and the President control fiscal policy. Fiscal policy is the use of either government spending— government purchases of final G/Ss and government transfers—or tax policy to stabilize the economy. Suppose the economy was in a recession. The government can intervene directly or indirectly. If the government increases spending (G), it will have a direct impact on AD by shifting AD to the right. If the government decreased taxes, this would increase disposable income, and this would increase consumption spending. The increase in C would shift the AD curve to the right, helping to indirectly reverse the recession.

SUMMARY—Monetary Policy The Federal Reserve controls monetary policy. The use of changes in the quantity of money or the interest rate to stabilize the economy. When the Fed increases the quantity of money in circulation, households and firms have more money, which they are willing to lend out. This drives the interest rate down at any given aggregate PL, leading to higher investment spending and higher consumer spending. Thus increasing the quantity of money shifts the AD curve to the right.