Introduction to AD/AS Model Aggregate Demand Introduction to AD/AS Model Most important model in AP Macro

Aggregate Supply & Demand Model Economists developed the AS/AD model to explain short-run fluctuations in Real GDP around its long-run trend Time Economic activity (Real GDP) Business cycle Long Run “full potential” Trend Line

AS & AD Model Price Level Real GDP (or output ) A measure of inflation (think CPI or GDP deflator) Real GDP (or output ) economy’s output of final goods and services

Aggregate Demand Aggregate-demand curve (AD)- how demand for the entire economy changes with inflation (price level) demand from households, firms, exports & government at each price level 4 Components of AD : AD = C + I + G + NX AD = C + I + G + NX

Shifts in AD Curve Shifts arise from changes in any of the 4 Determinants of AD Consumption Investment Government Purchases Net Exports AD = C + I + G + NX

3 Reasons AD is Downward Sloping AD = C + I + G + NX

Wealth Effect (consumption) As price level falls => real value of wealth/savings ↑ Consumers feel wealthier (purchasing power ↑) => spend more! Y = C + I + G + NX

Interest Rate Effect (Investment) A lower price level lowers real interest rates Why: consumers “hold” less money (save more money) More savings leads to lower real interest rates which raises Y = C + I + G + NX

Exchange Rate Effect A lower price level makes U.S. goods cheaper to foreigners Reduced “price” leads to more EXPORTS (U.S. exports look cheap!) Y = C + I + G + NX NX ↑

Worksheet Part I