AGGREGATE DEMAND

Aggregate Demand (AD) Shows the amount of Real GDP that the private, public and foreign sector collectively desire to purchase at each possible price level

Aggregate Demand (AD) AD curve measures the relationship between ◦ Overall price level  As measured by GDP deflator And ◦ Aggregate Demand  As measured by Real GDP (GDPr)  GDPr = C + I + G + Xn

PL GDP R AD Aggregate Demand Curve The relationship between the price level and the level of Real GDP is inverse

3 Reasons for Downward Sloping AD Curve Wealth Effect (real balances effect) Interest Rate Effect Foreign Purchases Effect (net export effect)

Reason 1 – Wealth Effect Wealth Effect (real-balances effect) ◦ An increase in the aggregate price level (ceteris paribas), reduces the purchasing power of assets Examples of assets: ◦ Bank account balance ◦ Certificates of ownership (stocks) ◦ Debt holdings (bonds)

Reason 1 - Wealth Effect As aggregate price level increases, purchasing power of assets declines People have less “wealth” ◦ Or The “real” value of the balance of their assets declines People reduce their consumption “C” goes down

Reason 2 – Interest Rate Effect Interest-Rate Effect ◦ price level  purchasing power of a given amount of money holdings ◦ To purchase the same basket of goods as before:  Need to convert non-money assets into money  OR - need to borrow more money ◦ Both reduce the funds available for lending ◦ Less money available for lending increases the price of money (Price of money = interest rate)

Reason 2 – The Interest Rate Effect Higher interest rates tend to discourage investment (because borrowed money costs more) “I” goes down Higher interest rates tend to encourage saving “C” goes down

Reason 3 – Foreign Purchase Effect Foreign Purchases Effect ◦ A higher price-level increases the demand for relatively cheaper imports ◦ “Nx” goes down

Shifts in Aggregate Demand (AD) There are two parts to a shift in AD: ◦ A change in C, I G, G and/or X N ◦ A multiplier effect that produces a greater change than the original change in the 4 components Increases in AD = AD  Decreases in AD = AD 

PL GDP R ADAD 1 Increase in Aggregate Demand

PL GDP R AD 1 AD Decrease in Aggregate Demand

Determinants of AD Consumption (C) Gross Private Investment (I G ) Government Spending (G) Net Exports (X N ) = Exports – Imports (X – M)

Shift Factors of AD Curve Changes in Expectations ◦ Affects consumer spending (C) and planned investment (I) Changes in Wealth ◦ When real value of assets rise, purchasing power increases  increase in aggregate spending Size of Existing Stock of Physical Capital ◦ More physical capital have now = less physical capital you need in future (all things equal)

Shift Factors of AD Curve Fiscal Policy ◦ Government policy of taxation and spending ◦ or  in government spending affects AD curve directly b/c of “G” ◦ or  in taxes affects AD curve indirectly b/c it changes disposable income  Leads to an increase or decrease in “C”

Shift Factors of AD Curve Monetary Policy ◦ Actions by the Federal Reserve System that affect the cost of money ◦ When supply of money , the cost of money goes down, leading to a decrease in interest rates ◦ When interest rates are lower, consumers spend more (C  ) and firms invest more (I  ) ◦ Shifts AD curve to the right

Consumption Household spending is affected by: ◦ Consumer wealth  More wealth = more spending (AD shifts  )  Less wealth = less spending (AD shifts  ) ◦ Consumer expectations  Positive expectations = more spending (AD shifts  )  Negative expectations = less spending (AD shifts  ) ◦ Household indebtedness  Less debt = more spending (AD shifts  )  More debt = less spending (AD shifts  ) ◦ Taxes  Less taxes = more spending (AD shifts  )  More taxes = less spending (AD shifts  )

Gross Private Investment Investment Spending is sensitive to: ◦ The Real Interest Rate  Lower Real Interest Rate = More Investment (AD  )  Higher Real Interest Rate = Less Investment (AD  ) ◦ Expected Returns  Higher Expected Returns = More Investment (AD  )  Lower Expected Returns = Less Investment (AD  )  Expected Returns are influenced by  Expectations of future profitability  Technology  Degree of Excess Capacity (Existing Stock of Capital)  Business Taxes

Government Spending More Government Spending (AD  ) Less Government Spending (AD  )

Net Exports Net Exports are sensitive to: ◦ Exchange Rates (International value of $)  Strong $ = More Imports and Fewer Exports = (AD  )  Weak $ = Fewer Imports and More Exports = (AD  ) ◦ Relative Income  Strong Foreign Economies = More Exports = (AD  )  Weak Foreign Economies = Less Exports = (AD  )

Summary AD reflects an inverse relationship between PL and GDP R Δ in PL creates real-balance, interest-rate, and foreign purchase effects that explain AD’s downward slope Δ in C, I G, G, and/or X N cause Δ in GDP R because they Δ AD. Increase in AD = AD  Decrease in AD = AD 