Unit 3: Aggregate Demand and Supply and Fiscal Policy 1

3.1 Aggregate Demand

Aggregate Demand Curve Price Level Real domestic output (GDP R ) AD 3 Applies similar concepts as the demand curve, except instead of dealing with the demand of one good, we are talking about the demand for all goods and services in an economy.

Aggregate- “added all together.” When we use aggregates we combine all prices and all quantities. Aggregate Demand is all the goods and services (real GDP) that buyers are willing and able to purchase at different price levels. The Demand for everything by everyone in the US. What is Aggregate Demand? 4 AD = C + I + G + X n

Price Level- General level of prices for goods and services in an economy. If all prices stay fixed for a while, the price level is unchanged, too. When inflation takes place, the price level arises. If the price level: Increases (Inflation), then real GDP demanded falls. Decreases (deflation), the real GDP demanded increases. What is Price Level? 5 There is an inverse relationship between price level and Real GDP.

Aggregate Demand Curve Price Level Real domestic output (GDP R ) AD 6 AD is the demand by consumers, businesses, government, and foreign countries Changes in price level cause a movement along the curve = C + I + G + Xn

Is AD downward sloping because of the law of demand? NO! The demand curve for an individual good shows how the quantity demand depends on the price of that good, holding the prices of other goods and services constant The main reason the quantity demanded falls as price goes up is because consumers switch to other relatively inexpensive goods Movement up or down the aggregate demand curve are a simultaneous change in the prices of all final goods and services 7

3 Reasons the AD curve is downward sloping: 1.The Wealth Effect Higher price levels reduce the purchasing power of money. This decreases the quantity of expenditures Lower price levels increase purchasing power and increase expenditures 8

3 Reasons the AD curve is downward sloping: 1.The Wealth Effect cont. Examples: Henry has $5,000 in his bank account. –If the aggregate price level were to rise by 25%, that $5,000 would buy only as much as $4,000 would have bought previously. What is Henry going to do? –The loss of purchasing power means Henry will scale back what he is going to buy If the price level doubles, people are going to buy less stuff because they have less purchasing power. So…price level goes up, GDP demanded goes down. 9

2. Interest-Rate Effect- When the price level increases, mean people and firms must hold more money to purchase the same amount of goods Thus, lenders have less money and need to charge higher interest rates to get a REAL return on their loans. Higher interest rates discourage consumer spending and business investment Reasons the AD curve is downward sloping:

2. Interest-Rate Effect Continued- When the price level falls, households need to hold less money to buy the goods and services they want. Households might use its excess money to buy bonds or deposit it in a bank, lowering interest rates Example: An increase in prices leads to an increase in the interest rate from 5% to 25%. You are less likely to take out loans to improve your business. So…price level goes up, GDP demanded goes down Reasons the AD curve is downward sloping:

3. Foreign Trade Effect- When U.S. price level rises, foreign buyers purchase fewer U.S. goods and Americans buy more foreign goods Exports fall and imports rise causing real GDP demanded to fall. (X N Decreases) Example: If prices triple in the US, Canada will no longer buy US goods causing quantity demanded of US products to fall. So…price level goes up, GDP demanded goes down 12 3 Reasons the AD curve is downward sloping:

Aggregate Demand Curve Price Level Real domestic output (GDP R ) AD 13 Changes in price level cause a movement along the curve = C + I + G + Xn

Shifters of Aggregate Demand 14 AD = GDP = C + I + G + X n

Shifts in Aggregate Demand Price Level Real domestic output (GDP R ) AD 15 An increase in spending shift AD right, and decrease in spending shifts it left = C + I + G + Xn AD 1 AD 2

4 Shifters of Aggregate Demand 1.Change in Consumer Spending Increase in Disposable Income (Higher incomes…) Consumer Expectations (People fear a recession…) Household Indebtedness (More consumer debt…) Taxes (Decrease in income taxes…) 16 AD = GDP = C + I + G + X n

4 Shifters of Aggregate Demand 2. Change in Investment Spending Real Interest Rates (Price of borrowing $) (If interest rates increase—AD shifts left…) Future Business Expectations (High expectations—AD shifts right…) Existing stock of physical capital (If relatively small—AD shifts right…) Business Taxes (Higher corporate taxes means—AD shift left…) 17 AD = GDP = C + I + G + X n

Shifters of Aggregate Demand 3.Change in Government Spending Government Expenditures (Decrease in defense spending—AD shift left…) (Increase in public works programs—AD shift right…) 18 AD = GDP = C + I + G + X n

Shifters of Aggregate Demand 19 4.Change in Net Exports (X-M) Exchange Rates (If the us dollar depreciates relative to the euro— AD shifts right…) National Income Compared to Abroad (If a major importer has a recession—AD shift left…) AD = GDP = C + I + G + X n

Shifts in Aggregate Demand Price Level Real domestic output (GDP R ) AD 20 Scenario: A widespread fear of impending recession = C + I + G + Xn AD 2 C ↓ and I ↓, so AD ↓

Shifts in Aggregate Demand Price Level Real domestic output (GDP R ) AD 21 Scenario: A significant boom in the stock market. = C + I + G + Xn AD 1 C ↑, so AD ↑

Shifts in Aggregate Demand Price Level Real domestic output (GDP R ) AD 22 Scenario: An increase in the incomes of a close trading partner = C + I + G + Xn AD 1 Exports ↑, so AD ↑

Shifts in Aggregate Demand Price Level Real domestic output (GDP R ) AD 23 Scenario: A decrease in government spending = C + I + G + Xn AD 2 G ↓, so AD ↓

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25 Look what happened during the last 5 recessions: