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CH.10- AGGREGATE DEMAND/AGGREGATE SUPPLY
BY J.A.SACCO
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Chapter deals with why business activity fluctuates. A way to explain changes in output/unemployment/price level.
Go Back to GDP
C+I+G+(X-M)
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C+I+G+(X-M)
The components of GDP determine the value of total expenditures. Consumers, Business Capital Investment, Government, Foreign Markets make these spending decisions.
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However, this much to simple an explanation. Two issues much be answered.
1. What determines the total amount that individuals, firms, governments, and foreigners want to spend?
2. What determines whether this spending will result in a higher output of goods/services (quantity) or higher prices (inflation)?
Answered by developing?
Aggregate Demand and Aggregate Supply
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Aggregate Demand- TOTAL of all planned expenditures for the entire economy.
Aggregate Supply- TOTAL of all planned production for the entire nation.
Aggregate Demand
Aggregate Demand Curve A curve showing planned purchase rates for
all goods and services in the economy at various price levels, all other things held constant
AD Curve is a shorthand way of illustrating the components of GDP.
Aggregate Demand
C+I+G+(X-M)
Furthermore, AD Curve gives the total amount of Real Domestic Income (RDI) that will be purchased at each price level. RDI = RGDP Remember Circular Flow.
8
AD
The Aggregate Demand Curve
Pri
ce L
evel/ G
DP D
eflato
r
Real GDP per Year($ trillions)
0 1 2 3 4 5 6 7 8 9 10
100
120
140
A
As the price levelrises, real GDPdemanded declinesB
C
9
AD
The Aggregate Demand Curve
Pri
ce L
evel/G
DP D
eflato
r
Real GDP per Year($ trillions)
0 1 2 3 4 5 6 7 8 9 10
100
120
140
C
As the price levelfalls, real GDPdemanded increasesB
A
Houston, We May Have a Problem!
Question- Why might the Law of Demand and the reasons for the downward slope of the demand curve not be applicable with aggregate demand.
Law of Demand (one good/service) states
Pr QD Pr QD
Houston, We May Have a Problem!
Now dealing with the entire macroeconomy. Price level is the average price of all goods and services including wages. Remember, when the price level for goods/service increased the consumer would substitute other goods/services. Now there are no substititues.
The Law of Demand still applies and the aggregate demand curve is still downward sloping but for different reasons.
Downward Slope of the Aggregate Demand Curve?
What Happens When the Price Level Changes? The Direct Effect: The Real-Balance Effect
(wealth effect) The Indirect Effect: The Interest Rate Effect The Open Economy Effect: The Substitution
of Foreign Goods
The Aggregate Demand Curve The Real-Balance Effect
The change in the real value (purchasing power) of money balances when the price level changes.
While your nominal cash value stays the same, any change in the price level will cause a change in the real value (purchasing power) of cash balances.
The Aggregate Demand Curve The Interest Rate Effect- Change in the
price level indirectly effects the interest rate.
1. When price level increases, you go out to replace your lost purchasing power.
2. This greater demand for money causes the nominal interest rate to increase.
3. As interest rates rise this makes borrowing less attractive thus reducing the quantity of AD.
Lets look at a Price Level increase.
A decrease in the price level works in the opposite direction.
The Aggregate Demand Curve The Open Economy Effect
Higher price levels result in foreigners’ desiring to buy fewer American-made goods while Americans desire more foreign-made goods (i.e. net exports fall)
This decline in net exports causes a decrease in the quantity of aggregate demand.
Review- A Change in the Price Level Direct Effect/Real Balance Effect/Wealth
EffectIf PL Purchasing Power
If PL
Rate of ConsumptionQuantity AD
Purchasing PowerRate of ConsumptionQuantity AD
Review- A Change in the Price Level Indirect Effect/ Interest Rate Effect
If PL Demand for Money
Nominal Interest Rate Consumption/ Investment
Quantity AD
Demand for Money Nominal Interest Rate Consumption/ Investment
Quantity AD
If PL
Review- A Change in the Price Level Open-Economy Effect
If PL U.S. goods/services more expensive than foreign. Substitute foreign goods for U.S. goods/services.
Quantity AD
If PL U.S. goods/services cheaper than foreign. More U.S. goods/services purchased than foreign. Quantity AD
Review- A Change in the Price Level Remember with any of these three
reasons, it is a change in the Price Level. You are only moving up/down the AD curve.
Non- Price Determinants of Aggregate Demand
Any non-price-level change that effects any component of:
C + I + G + (X-M) will cause a shift in the AD curve.
Non- Price Determinants of Aggregate Demand
Any non-price-level change that increases aggregate spending (on domestic goods) shifts AD to the right.
1. A drop in the foreign exchange value of the dollar2. Increased security about jobs and future income3. Improvements in economic conditions in other
countries4. A reduction in real interest rates (nominal interest
rates corrected for inflation) not due to price level changes
5. Tax decreases (Fiscal Policy)6. An increase in the amount of money in circulation
(Monetary Policy)
Shifts in the Aggregate Demand Curve
AD
GD
P D
eflato
r
Real GDP per Year($ trillions)
120
0 1 2 3 4 5 6 7
90
AD1
Increase inAggregateDemand
Determinants ofAggregate Demand
Any non-price-level change that decreases aggregate spending (on domestic goods) shifts AD to the left.
1. A rise in the foreign exchange value of the dollar2. Decreased security about jobs and future income3. Declines in economic conditions in other countries4. A rise in real interest rates (nominal interest rates
corrected for inflation) not due to price level changes
5. Tax increases (Fiscal Policy)6. An decrease in the amount of money in circulation
(Monetary Policy)
Shifts in theAggregate Demand Curve
AD
GD
P D
eflato
r
Real GDP per Year($ trillions)
120
0 1 2 3 4 5 6 7
90
AD1
Decrease inAggregateDemand
