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Aggregate Demand and Aggregate - 5 Components of Aggregate Demand › Aggregate Demand is the total level of planned spending on goods and services in an economy by households, businesses,

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  • Aggregate Demand and Aggregate Supply

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    Aggregate Demand and Aggregate Supply

    LEARNING OBJECTIVES

    1. Aggregate Demand (AD) has 5 Learning Objectives

    2. Aggregate Supply (AS) also has 5

    3. Macroeconomic Equilibrium in the AD/AS Model has 2

    The Learning Objectives in this presentation

    are covered in Chapter 20:

    Aggregate Demand and Aggregate Supply

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    Today, many economies, including the US, the UK and the Eurozone are suffering from weak GDP and high unemployment; some are still in recession.

    Most economists think the cause is a lack of Aggregate Demand (low levels of spending)

    The Aggregate Demand and Aggregate Supply Models help explain short-run fluctuations in Output, Prices and Employment.

    Making the Connection

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    Aggregate Demand (AD)

    LEARNING OBJECTIVES

    1. To understand Aggregate Demand (AD) is its components

    2. To understand why the AD Curve Slopes Downwards

    3. To identify the difference between a Movement Along the Curve and a Shift in the Curve

    4. To identify the variables that shift the AD curve

    5. To understand the impact of macroeconomic policy on AD

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    Components of Aggregate Demand

    › Aggregate Demand is the total level of planned spending on goods and services in an economy by households, businesses, government and foreign parties. AD (also sums to expenditure based GDP) and has four components:

    › Consumption (C)

    › Investment (I)

    › Government purchases (G)

    › Net Exports (NX)

    › If we let Y stand for AD, we can write the following: › Y = C + I + G + NX

    LEARNING OBJECTIVE: (1) ONE See Chapter 20 for more details

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    The Aggregate Demand Curve

    › The AD Curve shows the level of planned demand for real output consistent with a particular price level relationship

    Price Level (P)

    Real GDP (Y)

    Y1Y2

    P2

    P1

    AD

    LEARNING OBJECTIVE: (1) ONE See Chapter 20 for more details

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    Why does the AD Curve Slope Downwards?

    There are three main reasons for an inverse relationship between AD and the price level in an economy (i.e. a downward slope):

    1. The Wealth Effect

    › This affects consumption 2. The Interest Rate Effect

    › This affects investment 3. The International‐trade Effect

    › This affects net exports

    Price Level (P)

    Real GDP (Y)

    AD

    LEARNING OBJECTIVE: (1) TWO See Chapter 20 for more details

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    Why does the AD Curve Slope Downwards?

    How a Change in the price level affects Consumption | The Wealth Effect

    › When prices rise the money people have buys fewer goods and services, so real wealth is lower, people feel poorer and C goes down. P ⬆∴ AD ⬇

    How a change in the price level affects Investment | Interest‐Rate Effect

    › A rise in prices leads to increased money demand and rising interest rates. Investment is thus affected negatively. P ⬆∴ AD ⬇

    How a change in the price level affect Net exports | International‐Trade Effect

    › When prices rise, exports become more expensive and so foreign demand for them falls, at the same time imports become cheaper, thus net exports decline. P ⬆∴ AD ⬇

    LEARNING OBJECTIVE: (1) TWO See Chapter 20 for more details

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    Aggregate Demand Curve

    › Changes in P cause movements up or down a given AD Curve › An increase in P reduces the quantity of Goods and Services demanded

    because:

    › The wealth effect (C) falls

    › The interest‐rate effect (I) falls

    › The International‐Trade effect (NX) falls

    Price Level (P)

    Real GDP (Y)

    Y1Y2

    P2

    P1

    AD

    Y3

    P3

    A rise in the P from P1 to P2 causes a contraction in AD (moves up)

    A fall in P from P1 to P3 causes an expansion in AD (moves down)

    LEARNING OBJECTIVE: (1) TWO See Chapter 20 for more details

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    Shifts of the AD Curve Vs. Movements Along it

    › An important point to note is that the AD Curve – holding everything else constant – tells us the relationship between

    › the Price Level and the quantity of real GDP demanded in an economy

    › Only a change in the price level will cause a movement along an existing AD curve.

    › When any variable, other than price, changes and affects the willingness of firms, households and government to spend, then the AD will shift.

    LEARNING OBJECTIVE: (1) THREE See Chapter 20 for more details

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    Why might the AD Curve Shift?

    Any event that changes C, I, G, or NX – except a change in P – will cause a shift the AD Curve.

    Price Level (P)

    Real GDP (Y)

    Y1 Y2

    P1

    AD1 AD2

    LEARNING OBJECTIVE: (1) THREE See Chapter 20 for more details

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    Variables that Shift the AD Curve

    The variables that cause the AD curve to shift fall into four categories:

    Changes in…

    1. Business and household expectations

    2. Household wealth

    3. Foreign variables

    4. Government and Central Bank macroeconomic policies

    LEARNING OBJECTIVE: (1) FOUR See Chapter 20 for more details

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    Variables that Shift the AD Curve (1)

    1. Changes in the expectations of businesses and households

    › Household/business optimism or confidence about future income/profitability has a powerful affect on their spending and is affected by expectations about the future

    growth of the economy and inflation.

    2. Changes in household wealth

    › Wealth is the value of assets owned. Thus a change in house or share prices influences wealth and in turn also affects consumer confidence.

    3. Changes in foreign variables

    › A change in the value of the exchange rate and foreign income affects the demand for exports and the NX component of AD.

    LEARNING OBJECTIVE: (1) FOUR See Chapter 20 for more details

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    4. Changes in Government and Central Bank Policies

    › Fiscal policy | Refers to changes in government spending, welfare benefits and taxation and the amount the government borrows.

    › Changes in federal income tax, corporate taxes, government purchases and transfer payments, all affect AD.

    › Monetary policy | The actions the central bank takes to manage the money supply and interest rates to pursue macroeconomic policy objectives.

    › Changes in the interest rate affect the incentives of households and businesses to borrow and save.

    › The availability of credit from banks will also affect borrowing to finance consumption or investment.

    Variables that Shift the AD Curve (2) LEARNING OBJECTIVE: (1) FIVE See Chapter 20 for more details

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    Shifts in the AD Curve to the Right (Summary)

    Variables that Shift the AD Curve to the right:

    Price Level (P)

    Real GDP (Y)

    AD1 AD2

    An increase in…

    Government purchases

    Households’ expectations of their future incomes

    Firm’s expectations of the future profitability of investment spending

    shifts the AD Curve right because…

    These are components of aggregate demand

    Consumption spending increases

    Investment spending increases.

    LEARNING OBJECTIVE: (1) FIVE See Chapter 20 for more details

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    Shifts in the AD Curve to the Left (Summary)

    Variables that Shift the AD Curve to the left:

    Price Level (P)

    Real GDP (Y)

    AD2 AD1

    An increase in…

    Interest rates

    Taxes

    The growth rate of domestic GDP relative to that of foreign GDP

    The exchange rate (value of domestic currency) relative to foreign currencies.

    shifts the AD Curve left because…

    raises the cost of borrowing, reducing consumption and investment

    they cause consumption and investment to fall

    Exports will fall, reducing net exports

    Imports will rise and exports will fall, reducing net exports

    LEARNING OBJECTIVE: (1) FIVE See Chapter 20 for more details

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    The immediate cause has been a decline in aggregate demand. Due to:

    › A fall in consumer demand, resulting from high unemployment rates and a squeeze on real wages (frozen or even reduced);

    › Inflation and tax rises; › The government’s austerity programme

    is curtailing fiscal expenditure;

    › Export growth has been constrained by a slowing down in the global economy and especially in the Eurozone (the UK’s main trading partner);

    › Investment is being held back by pessimistic business sentiment and difficulties in raising finance.

    | Source: The Sloman Economics News site: http://pearsonblog.campaignserver.co.uk/?tag=aggregate-demand

    LEARNING OBJECTIVE: (1) FIVE See Chapter 20 for more details

    The UK economy shrank by a further 0.7% in Q2 of 2012, meaning that was the longest “double dip” recession in over 50 years.

    Making the Connection

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    Situations to Consider…

    Explain how and why

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