Chapter 7 Aggregate Demand and Aggregate Supply Hossain: MSMC

Aggregate Demand  Aggregate Demand is not same as just Demand we learnt in chapter 3.  In chapter 3, Demand was a relationship between  Price (P)  Quantity Demanded at that price (Qd)  According to the Law of Demand, if you recall, P and Qd had a negative relationship  Does anyone remember what that meant? Hossain: MSMC2

The Law of Demand  The negative relationship means two things:  When Price  When price Quantity demanded 3Hossain: MSMC Quantity demanded Copied from chapter 3

Aggregate Demand  Aggregate Demand is also a relationship between two important macro variables  Those are:  Price Level (P L )  Real GDP (Y)  There is a big difference, here  One concerns a single good or service (D)  The concerns the whole economy (AD) Hossain: MSMC4 It’s not the Quantity Demanded(Qd) Its not price (P)

Difference between P and P L  Price or P simply means price of any single good or service. Say price of apple or orange  Price Level or P L, on the other hand, is the average price of all goods and services combined  P L is typically captured by some sort of price index  Can anyone give me an example of a price index? Hossain: MSMC5 Very good, you are rightCPI is one, IPD is another

Difference between Q D and RGDP  Again, Quantity Demanded or Q D is for a single good or service.  RGDP is for the whole economy  However, there is a similarity  Both D and AD express a negative relationship  Which means, they both have Hossain: MSMC6 Negative Slope

Point on AD curve Price Level P L C +I +G +Xn=Xn=RGDP A1.188,4001,8202, ,800 B1.168,4501,8602, ,900 C1.148,5001,9002, ,000 D1.128,5501,9402, ,100 E1.108,6001,9802, ,200 A B C D E Aggregate Demand (AD)

Why AD is Downward Sloping  When P L rises, RGDP falls and when P L falls RGDP rises  This can be explained by following 3 effects: Hossain: MSMC8  Wealth Effect  Interest Rate Effect  International Trade Effect

Wealth Effect Hossain: MSMC9 When P L Rises  Value of saved asset or wealth (stock, bonds and savings) falls  People feel Poorer  Consumption (C) Falls  RGDP falls When P L Falls  Value of saved asset or wealth (stock, bonds and savings) rises  People feel Richer  Consumption (C) Rises  RGDP Rises

Interest Rate Effect Hossain: MSMC10 When P L Rises  People demand more Money  Interest rate Rises  Investment (I) Falls  RGDP falls  This channel is known as Interest Rate Effect When P L Falls  People demand Less Money  Interest rate Falls  Investment (I) Rises  RGDP Rises  This channel is known as Interest Rate Effect

International Trade Effect Hossain: MSMC11 When P L Rises  Export Falls  Import Rises  Net Export (X N ) Falls  RGDP falls  This channel is known as International Trade Effect When P L Falls  Export Rises  Import Falls  Net Export (X N ) Rises  RGDP risess  This channel is known as International Trade Effect

Point on AD curve Price Level P L C +I +G +X n =RGDP A1.188,4001,8202, ,800 B1.168,4501,8602, ,900 C1.148,5001,9002, ,000 D1.128,5501,9402, ,100 E1.108,6001,9802, ,200 From A to E P L is Falling C is Rising I is Rising G is Unchanged Xn is Rising RGDP is Rising

Change in AD  Because of Wealth Effect, Interest Rate Effect and International Trade Effect, when PL changes, RGDP changes in the Opposite Direction  This causes a Movement on a same AD curve  When some thing other than PL affect the AD, the whole AD curve shifts. Hossain: MSMC13 This is known as Change in AD

Change in AD  Note, change in P L will never shift the AD curve  But, changes in C, I, G and X N will  This is because they are all components of RGDP  For example, if businesses feel optimistic about 2011 and spend $10b in new investment (I), then this will increase RGDP at all possible P L  This means, AD will shift to the right Hossain: MSMC14

Change in AD AD 1 AD 2 AD 1 AD 2

Idea of Multiplier  Because of initial investment of $10b, RGDP will Directly rise by $10b almost immediately  However, there are Indirect boost to economy as well  Recall, someone spending is always someone else’s income  Investment spending will also increase incomes and wages in the economy  With higher income, consumption (C) will rise Hossain: MSMC16

Idea of Multiplier  Increased Consumption (c) will further increase the RGDP  But, Cycle does not stop there.  Because of consumption spending, someone else’s income rises and induces more consumption by the person whose income has rises  When all is over, economy observes a much larger increase than initial investment spending. Hossain: MSMC17

Idea of Multiplier  Multiplier measures, how many times the final RGDP rises compared to initial spending  Formula: Multiplier = Exercise: if $10b investment increases the RGDP by $25b, compute the multiplier Hossain: MSMC18 Change in Initial Component of AD Change in Final RGDP

The Multiplier AD 1 AD 2 Effect of initial increase in net exports without multiplier effect

The Multiplier AD 1 AD 2 Effect of initial decrease in net exports without multiplier effect