Warm-up: Turn to your neighbor and explain the following: (Guess if necessary!!!) Cost-push inflation (Person with the longest hair does the talking) Demand-pull inflation (Person with the shortest hair does the talking)

Aggregate Demand IB Economics

Aggregate Demand Macro concept – WHOLE economy The sum total of all goods and services demanded in the economy (all final markets) AD is related to the price level—the average of all prices Formula: AD = C+I+G+(X-M) C= Consumption Spending I = Investment Spending G = Government Spending (X-M) = difference between spending on imports and receipts from exports (Balance of Payments)

Aggregate Demand Curve Shows the amounts of real output that buyers collectively desire to purchase at each possible price level The relationship between the price level and the amount of real GDP demanded is inverse or negative When price level rises, the quantity of real GDP demanded decreases and vice versa

Aggregate Demand Curve Price Level AD Real GDP

The Downward Sloping Aggregate Demand Curve-overview Real-balance effect (a.k.a. Real Wealth Effect) Interest-Rate effect Foreign Purchases Effect

Aggregate Demand Curve Shape 1. Real-Balances/Wealth Effect As prices rise the value of bank balances fall. Because the public is poorer in real terms, they will reduce their spending Purchase a new car or LCD TV if savings has purchasing power of $50,000 If inflation erodes the purchasing power of its asset balances to say $30,000, then the household may wait to make its purchases Higher price level = less consumption spending as people act to maintain their real money balances Conversely, lower price levels = more consumption spending

Aggregate Demand Curve Shape 2. Interest-Rate Effect Assume supply of money to be constant or fixed when drawing the AD Curve However, when price level increases, consumers need more money for purchases and businesses need more money to meet their payrolls and to buy other resources Higher price level increases the demand for money Fixed supply of money an increase in money demanded = increase in the price paid for its use INTEREST RATE

Aggregate Demand Curve Shape 2. Interest-Rate Effect continued . . . Higher interest rates reduce investment spending and interest-sensitive consumption spending If 6% rate of return is expected on capital, then: At 5% interest rate investment is made At 7% interest rate the investment is not made Increasing the demand on money & consequently the interest rate, a higher price level reduces the amount of real output demanded

Aggregate Demand Curve Shape 3. Foreign Purchases Effect (a. k. a Aggregate Demand Curve Shape 3. Foreign Purchases Effect (a.k.a. Net Export Effect) When U.S. price level rises relative to foreign price levels, then: Foreigners buy fewer U.S. goods (X), & Americans buy more foreign goods (M) Rise in the price level reduces the quantity of U.S. goods demanded as net exports U.S. Exports Fall U.S. Imports Rise

Shifts in the Aggregate Demand Curve Determinants of AD “Other things” besides price level Resulting in Shifts or change in AD Price Level AD2 AD Real GDP

Factors causing AD to SHIFT - Overview Fiscal Policy Monetary Policy Foreign Income Changes & Exchange Rates Future Expectations External Shocks

AD Shift – Fiscal Policy Definition: Taxes Government Spending

AD Shift - Monetary Policy Definition: Assume increase MS Investment Consumer Durables Savings

AD Shift -Foreign Income Changes Income of foreigners is major determinant of demand If NI of country A increases then X of country B will increase.

AD Shift - Exchange Rates Value of $ decreasing Value of $ increasing

AD Shift – Future Expectations Future prices Business outlook Future income changes

AD shift – Demand side shock (aka external shocks) National, international, social, and natural events can effect consumers, firms, government and thus AD.

Aggregate Demand Exercise Complete the exercise for Aggregate Demand