ECO 104 Aggregate Demand and Aggregate Supply Ch. 8, Macroeconomics, R.A. Arnold

A Way To View The Economy Two major economic activities : BUYING and PRODUCING Aggregate Demand (AD) => BUYING Aggregate Supply (AS) => PRODUCING ( 2 time periods) Short run AS (SRAS) => production in the short run Long run AS (LRAS) => production in the long run

Aggregate Demand (AD) Aggregate Demand : The quantity demanded of all goods and services (Real GDP) at different price levels, ceteris paribus. AD curve => graphical representation of aggregate demand

Explaining the Downward Slope of AD Curve The inverse (negative) relationship between price level (P) and AD is explained by Real balance effect : if, P ↓ then, purchasing power ↑ hence, quantity demanded of Real GDP (all goods and services) ↑ … if, P ↑ then, purchasing power ↓ hence, quantity demanded of Real GDP (all goods and services) ↓ The interest rate effect : if, P ↓ then, credit supply ↑ because households save more and hence, interest rate ↓ therefore, quantity demanded of Real GDP ↑ …if, P ↑ the opposite occurs The international trade effect : if, P (domestic goods) ↓ then, domestic goods are cheaper as compared to foreign goods and hence, domestic citizens and foreigners buy more of domestic goods; quantity demanded of Real GDP ↑ … if, P (domestic goods) ↑ the opposite occurs

A Change in Quantity Demanded of Real GDP: Movement Along the AD Curve A change in quantity demanded occurs ONLY due to a change in the price level in the economy resulting in movement along the aggregate demand curve (similar to change in quantity demanded of a single good due to a change in it’s own price, ch. 3) Exhibit 3 (p. 169, ch. 8, Macroeconomics, Arnold). Please read !

A Change in Aggregate Demand: Shift in AD curve Spending increases at given price level (P) → AD rises (shifts right) Spending decreases at given price level (P) → AD falls (shifts left) Total spending (expenditure) = Real GDP = C + I + G + NX (adjusted for price changes) (Exports – Imports) Therefore, AD shifts if either, C, I, G or NX changes… More precisely, if either C,I,G or NX ↑ (ceteris paribus), AD shifts right And if either C,I,G or NX ↓ (ceteris paribus), AD shifts left

Consumption (C) Four factors affect/change consumption: Wealth (monetary and non-monetary assets) : If wealth ↑ then C ↑ hence AD ↑ (shifts right) Similarly if, wealth ↓ then C ↓ AD ↓ (shifts left) (2) Expectations of future prices E (P) and income E (Y) If, E (P) ↑ then C ↑ hence AD ↑ (shifts right) If, E (P) ↓ then C ↓ hence AD ↓ (shifts left) If, E (Y) ↑ then C ↑ hence AD ↑ (shifts right) If, E (Y) ↓ then C ↓ hence AD ↓ (shifts right)

(3) The interest rate (i) - Consumer durables (usually paid by borrowing) are sensitive to interest rate Therefore if interest rate ↑, C ↓, AD ↓ (AD curve shifts left) Similarly, if interest rate ↓, C ↑, AD ↑ (AD curve shifts right) (4) Income taxes (T) if T ↑, Disposable income ↓, C ↓, AD ↓ (AD curve shifts left) if T↓, Disposable income ↑, C ↑, AD ↑ (AD curve shifts right)

Investment (I) Three factors affect investment (I) Interest Rate (r) : If (r) increases then cost of investment increases and hence, (I) decreases, hence, AD decreases (AD curve shifts left) Expectations about future sales E (S) : If E (S) increases, then (I) increases and hence, AD increases (AD curve shifts right) Business taxes : Increase in business taxes lowers expected profit and hence businesses invest less and AD decreases (AD curve shifts left) PS. The opposite changes have been left as an exercise - an incentive for you to open the book!

NET EXPORTS (NX) NX = Exports (EX) – Imports (IM) Affected by Foreign Real National Income (NI) and Exchange Rate If Foreign Real (NI) increases, foreigners buy more of domestic goods, hence, (EX) increases, ceteris paribus, (NX) increases and therefore AD increases (shifts right) The opposite is true as well

Exchange Rate : e.g. in 2014: BDT 60 = $ 1 … in 2015: BDT 70 = $ 1 More BDT (Taka) is needed to buy $1 in 2015. Therefore, the Taka has depreciated against the U.S dollar OR the dollar has appreciated… Hence, U.S. goods more expensive in 2015. So people will import less from U.S … hence, imports ‘IM’ fall. But since ‘$’ has appreciated, BD goods are now cheaper for U.S. citizens and importers…so export ‘EX’ ( of BD) increases We know, NX = EX – IM and since EX↑ and IM ↓ …NX ↑ AD ↑ (rightward shift)

Similarly, If BDT (Taka) appreciates…then BD goods become more expensive for foreigners, BD export falls. But now foreign goods are cheaper…so import increases And since, NX = export – import NX falls, hence AD falls and AD curve shifts left