Introduction to AD/AS Model Aggregate Demand Introduction to AD/AS Model

Diminishing Marginal Utility The Substitution Effect Microeconomic Demand Curve REVIEW– Why is demand curve downward sloping? Diminishing Marginal Utility and The Substitution Effect T-Shirts Price D1 Qty

Aggregate Supply & Demand Model Economists use this model to explain short-run fluctuations in economic activity around its long-run trend Time Economic activity Business cycle Long Run Trend Line

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

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

The four components of GDP (Y) equal aggregate demand (AD) AD =Y = C + I + G + NX Price Level Aggregate (AD) demand P Y 3-Factors make it downward sloping 1. A decrease in the price level . . . Y2 P2 Real GDP 2. . . . increases the quantity of goods and services demanded.

Why the AD curve is Downward Sloping The Wealth Effect The Interest Rate Effect Exchange Rate Effect Y = C + I + G + NX

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

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

Exchange Rate Effect A lower price level makes domestic goods appear cheaper to foreigners Reduced “price” leads to more EXPORTS Y = C + I + G + NX Price Level GDP (Y)

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