1. Aggregate Demand (AD)  Shows the amount of Real GDP that the private, public and foreign sector collectively desire to purchase at each possible price level  The relationship between the price level and the level of Real GDP is inverse

2. Three Reasons AD is downward sloping -- 1  Aggregate Spending Constraint  There is a fixed amount of money in the market.  This is the key to understanding why although both D and AD slope downward, they do so for very different reasons!

3. Three Reasons AD is downward sloping -- 2  Real-Balances Effect  When the price-level is high households and businesses cannot afford to purchase as much output.  When the price-level is low households and businesses can afford to purchase more output.

4. Three Reasons AD is downward sloping -- 3  Interest-Rate Effect  A higher price-level increases the interest rate which tends to discourage investment  A lower price-level decreases the interest rate which tends to encourage investment

5. Three Reasons AD is downward sloping -- 4  Foreign Purchases Effect  A higher price-level increases the demand for relatively cheaper imports  A lower price-level increases the foreign demand for relatively cheaper U.S. exports

6. Long-Run v. Short-Run  Long-Run  Period of time where input prices are completely flexible and adjust to changes in the price- level  In the long-run, the level of Real GDP supplied is independent of the price-level  Short-Run  Period of time where input prices are sticky and do not adjust to changes in the price- level  In the short-run, the level of Real GDP supplied is directly related to the price level

7. Long-Run Aggregate Supply (LRAS)  The Long-Run Aggregate Supply or LRAS marks the level of full employment in the economy (analogous to PPC)  Because input prices are completely flexible in the long-run, changes in price-level do not change firms’ real profits and therefore do not change firms’ level of output. This means that the LRAS is vertical at the economy’s level of full employment

8. Short-Run Aggregate Supply (SRAS)  Because input prices are sticky in the short-run, the SRAS is upward sloping. This reflects the fact that in the short-run, increases in the price-level increase firm’s profits and create incentives to increase output. As the price-level falls, firm’s profits drop and this creates an incentive to reduce output.

9. The AS/AD Model  The equilibrium of AS & AD determines current output (GDP R ) and the price level (PL)

10. Full Employment  Full Employment equilibrium exists where AD intersects SRAS & LRAS at the same point.

11. Recessionary Gap  A recessionary gap exists when equilibrium occurs below full employment output.  An inflationary gap exists when equilibrium occurs beyond full employment output.

12. Shifts in Aggregate Demand (AD)  There are two parts to a shift in AD:  A change in C, I G, G and/or X N  A multiplier effect that produces a greater change than the original change in the 4 components  Increases in AD = AD   Decreases in AD = AD 

13. Determinants of AD  Consumption (C)  Gross Private Investment (I G )  Government Spending (G)  Net Exports (X N ) = Exports - Imports (X – M)

14. Consumption  Household spending is affected by:  Consumer wealth  More wealth = more spending (AD shifts  )  Less wealth = less spending (AD shifts  )  Consumer expectations  Positive expectations = more spending (AD shifts  )  Negative expectations = less spending (AD shifts  )

15. Consumption cont.  Household spending is affected by:  Household indebtedness  Less debt = more spending (AD shifts  )  More debt = less spending (AD shifts  )  Taxes  Less taxes = more spending (AD shifts  )  More taxes = less spending (AD shifts  )

16. Gross Private Investment  Investment Spending is sensitive to:  The Real Interest Rate  Lower Real Interest Rate = More Investment (AD  )  Higher Real Interest Rate = Less Investment (AD  )

17. Gross Private Investment cont.  Investment Spending is sensitive to:  Expected Returns  Higher Expected Returns = More Investment (AD  )  Lower Expected Returns = Less Investment (AD  )  Expected Returns are influenced by  Expectations of future profitability  Technology  Degree of Excess Capacity (Existing Stock of Capital)  Business Taxes

18. Government Spending  More Government Spending (AD  )  Less Government Spending (AD  )

19. Net Exports  Net Exports are sensitive to:  Exchange Rates (International value of $)  Strong $ = More Imports and Fewer Exports = (AD  )  Weak $ = Fewer Imports and More Exports = (AD  )  Relative Income  Strong Foreign Economies = More Exports = (AD  )  Weak Foreign Economies = Less Exports = (AD  )

20. Summary  AD reflects an inverse relationship between PL and GDP R  Δ in PL creates real-balance, interest- rate, and foreign purchase effects that explain AD’s downward slope  Δ in C, I G, G, and/or X N cause Δ in GDP R because they Δ AD.  Increase in AD = AD   Decrease in AD = AD 