Macroeconomic Models Aggregate Demand and the Aggregate Demand Curve What framework can we use to: 1) Analyze the three main objectives for an economy? ____________________ 2) Establish the connection between Macroeconomic Objectives and Government Policy?

IB Syllabus: Aggregate Demand The AD curve  Distinguish between the microeconomic demand for a product and the macroeconomic concept of aggregate demand  Construct an aggregate demand curve  Explain why the AD curve has a negative slope The Components of AD  Describe Consumption, Investment, Government Spending, and Net Exports as the components of AD The Determinants of AD/Causes of Shifts in AD  Explain how the AD curve can be shifted by changes in C  Explain how the AD curve can be shifted by changes in I  Explain how the AD curve can be shifted by changes in G  Explain how the AD curve can be shifted by changes in X-M

Aggregate Demand Aggregate Demand: The total quantity of goods and services that all buyers in an economy want to buy at different possible price levels, ceteris paribus. Includes the aggregate demand of: Consumers (C) Businesses/Firms (I) Government (G) Foreigners for exports, less the demand for imports (X-M)

The AD Curve The Aggregate Demand (AD) Curve—the relationship between: The sum (or aggregate) of all the demand for all the goods and services in all final markets (the Real GDP), and The economy’s overall price level AD = C + I + G + NetX Slopes downward – appears like the D curve, but in reality QUITE DIFFERENT! Note the axes: Price Level (vertical) and Real GDP (horizontal) Price Level: We use “GDP Deflator” for a given base year as our “100” for any measure of price levels across an entire economy

A Basic AD Curve Real GDP, 2004 dollars (billions) GDP Deflator, 2004 = 100

Mommy, why does the AD curve slope downwards? 1.Wealth Effect 2.Interest Rate Effect 3.International Trade Effect (Net Export Effect) 1. The Wealth Effect As Price Level (average price of goods and services) rises, your money purchases less, you can consume less real GDP As Price Level falls, your real income rises, and AD rises (spend / consume more real GDP)

Downward Sloping AD Curve 2. The Interest Rate Effect As Prices increase, consumers/firms need more money (to carry out purchases); ceteris paribus, they increase borrowing/have a higher demand for money A higher demand for money leads to higher interest rates (assume the supply of money is constant) Higher interest rates lead to less borrowing, so C & I decrease, leading to reduced AD 3. The International Substitution Effect If Price Levels increase, Exports become more expensive, and net exports therefore decrease; Imports are relatively less expensive and increase. X-M decreases, so AD decreases

Changes in AD – Shifts in the Curve Changes/Shifts ≠ Movements along the AD curve Movements: Caused by changes in the price level Shifts: Outward/rightward when AD increases; inward/leftward when AD decreases Important note: Changes in income do not shift the AD curve

Changes in AD: Changes in C Changes in Wealth Changes in Expectations about future income, and expectations of future changes in the economy Changes in Interest Rates Changes in Personal Income Taxes Changes in Household Debt Changes in Attitudes towards spending

Changes in AD: Changes in I Changes in expectations about future sales Changes (improvements) in technology Changes in Interest Rates Changes in Business Taxes Legal/Institutional Changes

Changes in AD: Changes in G Changes in political priorities Deliberate efforts to influence aggregate demand Changes in AD: Changes in X-M Changes in real national income abroad Changes in exchange rates