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

2. 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

3. 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

4. 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

5. 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

6. 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
increases the quantity of
goods and services demanded.

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

8. 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)

9. 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)

10. 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)

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

12. Worksheet Part I