1. ECON203 Principles of Macroeconomics Week 8 Topic: Aggregate Demand
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ECON203 Principles of Macroeconomics Week 8 Topic: Aggregate Demand
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Dr. Mazharul Islam
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2. Learning outcomes for student revision
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Learning outcomes for student revision
To learn about
After studying these topics you should be able to:
Understand the meaning and factors that affect Aggregate Demand.
Show changes using an AD and explain their output and price implications
Explain the meaning and differences between Equilibrium output (Ye) and Potential output (YP) and why and how they will change
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3. ECON582
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Aggregate Demand
Aggregate Demand:It is the relationship between the quantity of real GDP demanded and the price level when other influences on expenditure plans remain the same.
This relationship as follows:
Other things remaining the same, the higher the price level , the smaller is the quantity of real GDP demanded; and the lower the price level, the greater is the quantity of real GDP demanded .
When we move along AD curve in following Figure, we assume that price level changes But that other influences on equilibrium GDP are constant
Keep following rule in mind
When a change in price level causes real GDP demanded to change, we move along AD curve.
Whenever anything other than price level causes real GDP demanded to change, AD curve itself shifts.
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4. Aggregate Demand Fundamentals
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The quantity of real GDP demanded (Y) is the total amount of final goods and services produced in Saudi Arabia that people, businesses, governments, and foreigners plan to buy.
This quantity is the sum of planned:
consumption expenditures (C),
investment (I),
government spending (G), and
exports minus imports (net exports), (X – M).
That is: Y = C + I + G + (X – M) = GDP (expenditure measure)
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5. Aggregate Demand Curve
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Aggregate Demand Curve
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6. Aggregate Demand Curve - Downward slope.
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Aggregate Demand Curve - Downward slope.
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“the higher (lower) the price level the smaller (greater) the quantity of real GDP demanded” when other things are constant. Because a change in the price level brings a change in: 1.The buying power of money 2. The real interest rate 3. The real prices of exports and imports
The buying power of money (Wealth Effect)
A rise in the price level lowers the buying power of money. That means the same quantity of money can not buy the same quantity of goods and services as price level increases. As prices rise the buying power of your wealth ________ and the quantity of Saudi Arabia’s real GDP demanded ________
Wealth effect (real wealth is the buying power of all your assets)
Drops
Decrease
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7. Aggregate Demand Curve - Downward slope
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Aggregate Demand Curve - Downward slope
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When the price level ( )demand for money (the amount of money that people want to hold) ( ), the nominal interest rate ( )the real interest rate ( ).
Faced with higher real interest rate, businesses and people delay plans to buy new capital and consumer durable goods and they will decrease spending.
As prices rise the interest rate ________ and the quantity of Saudi Arabia’s real GDP demanded ________ .
Increase
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Decrease
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8. Aggregate Demand Curve - Downward slope
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Aggregate Demand Curve - Downward slope
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The Real Prices of Exports & Imports (Substitute Effects)
When the country's price level increases and the prices in other countries do not change
local made goods and services will be more expensive than the foreign made items.
People will spend less on local made items and that means a decrease in real GDP demanded.
As prices rise export buyers will tend to buy________ and Saudi People will buy ______ imports, so the quantity of KSA’s real GDP demanded _________
Less
More
Decrease
Dr. Mazharul Islam
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9. Aggregate Demand Curve - Downward slope
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Price Level
Price level ↑ moves us leftward along the AD curve P3
Price level ↓ moves us rightward along the AD curve P1 P2 AD Q3 Q1 Q2
Real GDP
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10. Changes in Aggregate Demand.
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Changes in Aggregate Demand.
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A change in any factor other than the price level brings a change in aggregate demand and aggregate demand curve shifts to the right (aggregate demand increases)or to the left(aggregate demand decreases) .
The factors are :
Expectations about the future (concerning economic, political and social factors)
Government Economic Policies (Fiscal and monetary policies)
The state of the world economy (net exports)
Real GDP demanded will change whenever there is a change in any of the following
Government purchases
Autonomous consumption spending
Investment spending
Net exports
Taxes
Money supply
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11. Changes in AD (Shift of the AD curve) for expectation
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Changes in AD (Shift of the AD curve) for expectation
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With same price level
Expected higher future income-AD (Rightward)
Expected lower future income-AD (Leftward)
Expected higher future inflation-AD (Rightward)
Expected lower future inflation-AD (Leftward)
Expected higher future profits-AD (Rightward)
Expected lower future profits-AD (Leftward)
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12. Changes in AD (Shift of the AD curve) for government policies
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With same price level
Expansionary fiscal policy (tax ,G ,TP )-AD (Rightward)
Contractionary fiscal policy (tax ,G ,TP )-AD (Leftward)
Expansionary monetary policy (i MS ) -AD (Rightward)
Contractionary monetary policy(i MS )-AD (Leftward)
AD curve shifts rightward when government purchases, investment spending, autonomous consumption spending, or net exports increase, or when taxes decrease.
AD curve shifts leftward when government purchases, investment spending, autonomous consumption spending, or net exports decrease, or when taxes increase
TP = Government’s welfare (financial aid), social security, subsidies, etc. without any exchange of goods and services
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13. Changes in AD (Shift of the AD curve) for state of the world economy
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With same price level
Better world economy (foreign income )-AD (Rightward)
Worse world economy (foreign income )-AD (Leftward)
Lower exchange rate (X M ) -AD (Rightward)
Higher exchange rate (X M ) -AD (Leftward)
The demand for domestic currency falls (Rise) and the demand for foreign currency rises (fall) causing a decrease (increase) in the exchange rate (the value of the domestic currency is now lower (higher) relative to foreign currencies)
A lower exchange rate causes the aggregate demand increase (because local goods and services become cheaper than foreign goods and services and exports will increase and imports will decrease).
A higher exchange rate causes the aggregate demand decrease (because foreign goods and services become cheaper than local goods and services and exports will decrease and imports will increase).
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14. Changes in AD (Shift of the AD curve)
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Price
Level
Price
Level
Entire AD curve shifts rightward if:
a, I, TP, G, or NX increases
Net taxes, i decrease
The money supply increases
Entire AD curve shifts leftward if:
a, I, TP, G, or NX decreases
Net taxes, i increase
The money supply decrease
AD curve shifts rightward when government purchases, investment spending, autonomous consumption spending, or net exports increase, or when taxes decrease.
AD curve shifts leftward when government purchases, investment spending, autonomous consumption spending, or net exports decrease, or when taxes increase
AD2
AD1
AD1
AD2
Real GDP
Real GDP
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15. Macroeconomic Equilibrium (short-run)
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Macroeconomic Equilibrium (short-run)
Occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied at the point of intersection of the AD curve and the SAS curve.
i.e. AD = SAS shows where the economy is NOW
Only at this combination of prices and production can firms sell all their output and people buy all the goods and services they demand.
Short-run equilibrium is the normal state of the economy as it fluctuates around potential GDP.
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16. Short-Run Equilibrium – Graph
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Short-Run Equilibrium – Graph
Price Level
125
SAS
115
105
Short-run
macroeconomic
equilibrium 95
Short-run macroeconomic equilibrium. Emphasize that in short-run macroeconomic equilibrium, firms are producing the quantities that maximize profit and everyone is spending the amount that they want to spend. 85 AD
Real GDP
860
880
900
920
940
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17. Explaining Macroeconomic Fluctuations
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Explaining Macroeconomic Fluctuations
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Figure 10.6 illustrates a short-run equilibrium.
If real GDP is below equilibrium GDP, firms increase production and raise prices…
… and if real GDP is above equilibrium GDP, firms decrease production and lower prices.
In short-run equilibrium, real GDP can be greater than or less than potential GDP.
Firms always produce the profit-maximizing quantities—the economy is on the SAS curve. If they can’t sell everything they produce, firms lower prices and cut production. Similarly, if they can’t keep up with sales and inventories are falling, firms raise prices and increase production. These adjustment processes continues until firms are selling their profit-maximizing output. Emphasize also that with a fixed (sticky) money wage rate, this short-run equilibrium can be at, below, or above potential GDP.
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18. What Happens When Things Change?
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What Happens When Things Change?
Our short-run equilibrium will change when either AD curve, SAS curve, or both, shift
An event that causes AD curve to shift is called a demand shock.
An event that causes AS curve to shift is called a supply shock.
A change in spending by one or more sectors that ultimately affects entire economy
Demand shocks and supply shocks are just two different categories of spending shocks
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19. The Effect of a Demand Shock in short-run
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The Effect of a Demand Shock in short-run
Price Level
SAS
130 H
115 J
100 E
Point ‘H’ is the new equilibrium point in the short-run due to demand shock.
AD2
AD1 10
13.5
Real GDP($ Trillions)
12.5
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20. An Increase in Government Purchases
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An Increase in Government Purchases
An Increase in Money Supply
When government purchases increase, horizontal shift of AD curve measures how much real GDP would increase if price level remained constant
But because price level rises, real GDP rises by less than horizontal shift in AD curve because-----above explanation.
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21. Inflationary and Recessionary Gap
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Inflationary and Recessionary Gap
The amount by which real GDP exceeds potential GDP is called a inflationary gap.
The amount by which real GDP is less than potential GDP is called a recessionary gap.
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22. Thinking time………………….. Question 1: Home Work Question (4 marks)
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Thinking time…………………..
Question 1: Home Work Question (4 marks)
Using the AD/AS model, show and explain (using four separate diagrams) the likely impact of the following events on KSA’s prices and output. Consider the economy initially at full employment.
Consumer confidence strengthens
The world experiences a strong resources price boom.
Oil prices fall substantially
There’s a significant technological development and improvement.
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23. Thinking time………………….. Question 2: Home Work Question (4 marks)
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Thinking time…………………..
Question 2: Home Work Question (4 marks)
Draw on an AD/AS graph the expected impacts of the following factors and explain the effects on the economy.
A falling stock market
Increasing labour market participation
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24. Now it’s over for today. Do you have any question?
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Now it’s over for today. Do you have any question?
Dr. Mazharul Islam
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