Aggregate DemandChapter 9

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Principles of Economics:Macroeconomics - Econ101

9-2

Aggregate Demand• Aggregate demand: The total

quantity of output (real GDP) demanded at alternative price levels in a given time period, ceteris paribus

• The aggregate demand curve illustrates how the real value of purchases varies with the average level of prices

• The downward slope suggests that with a given (constant) income, at lower price levels people will buy more goods and services

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Three Reasons for the Downward SlopeWealth Effect:The change in the purchasing power of dollar-denominated assets that results from a change in the price level.

International Trade Effect:The change in foreign sector spending as the price level changes.

Interest Rate Effect:Changes in household and business buying as the interest rate changes.

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Components of Aggregate Demand

• The four components of aggregate demand are– Consumption (C)– Investment (I)– Government spending (G)– Net exports (X – M)

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Determinants of AD on (C)

Wealth ↓ → C ↓ → AD ↓

1. Wealth - The value of all assets owned, bothmonetary and non- monetary

Expect higher future prices → C↑ → AD↑

Expect lower future prices → C↓ → AD↓

2. Expected Future Prices

Wealth ↑ → C ↑ → AD ↑

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Determinants of AD on (C)

Expect lower future income → C↓ → AD↓

Expect higher future income → C ↑ →A D↑

3. Expected Future Income

Interest Rate ↑ → C↓ → AD↓

Interest Rate ↓ → C ↑ → AD↑

4. Interest Rates

Income taxes ↑ → C↓ → AD↓

Income taxes ↓ → C ↑ → AD↑

5. Income Taxes

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Determinants of AD on (I)

Interest rates ↑ → I↓ → AD↓

Interest rates ↓ → I ↑ → AD↑

1. Interest Rates

Pessimistic about future sales → I↓ → AD↓

Optimistic about future sales → I ↑ → AD↑

2. Expected Future Sales

Business taxes↑ → I↓ → AD↓

Business taxes↓ → I↑ → AD↑

3. Business Taxes

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Determinants of AD on (NE)

Foreign real national income ↓ → EX↓ → NX↓ →AD↓

Foreign real national income ↑ → EX↑ → NX↑ →AD↑

US $ appreciates → EX↓ and IM ↑ → NX↓ →AD↓

US $ depreciates → EX↑ and IM ↓ → NX↑ →AD↑

2. Exchange Rates

1. Foreign Income

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Aggregate Supply• Aggregate supply: The

total quantity of output (real GDP) producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus

• Two reasons for upward sloping curve:– The profit effect– The cost effect

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The Short-Run Aggregate Supply Curve (SRAS) Slopes Upward…………..

….because over the short-run, as the price level increases, the quantity of goods and services firms are willing to supply will

increase.

As prices of final goods & services rise, prices of inputs, such as the wages of workers or the price of a natural resources, rise

more slowly. Profits rise when the prices of the goods & services firms sell rise more rapidly than the prices they pay for

inputs.

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Factors that Shift the Short-Run Aggregate Supply Curve (SRAS)

Wage rates

Productivity

Supply shocks Adverse Beneficial

9-12

Macro Equilibrium• Aggregate supply and

demand curves summarize the market activity of the whole (macro) economy

• Equilibrium (macro): The combination of price level and real output that is compatible with both aggregate demand and aggregate supply

PR

ICE

LE

VE

L

REAL OUTPUT

QE

PE

Aggregatedemand

Aggregatesupply

E

D1 S1

P1

Macro equilibrium

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Competing Theories of Short-Run Instability

• Macro controversies focus on the shape of aggregate supply and demand curves and the potential to shift them

• Demand-side theories, such as Keynesian and Monetary, emphasize aggregate-demand shifts

• Supply-side theories center on shifts in supply

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Keynesian Theory

• Keynes argued that a deficiency of spending tends to depress an economy and cause persistently high unemployment

• Advocated increasing government spending – a rightward AD shift – to move the economy toward full employment

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Monetary Theories

• Monetary Theories emphasize the role of money in financing aggregate demand

• Money and credit affect ability and willingness to buy goods and services

• If credit isn’t available or is too expensive consumers reduce spending and businesses curtail investment

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Supply-Side Theories

• Inadequate supply can keep the economy below its full-employment potential and cause prices to rise as well

• Increases in aggregate supply move us closer to goals of price stability and full employment

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Long-Run Self Adjustment

• Some economists argue that the long-run trend of the economy is what really matters, not short-run fluctuations

• They assert a long-run aggregate supply curve anchored at the natural rate of output (QN)– Flexible prices (and wages) enable the economy to

maintain the natural rate of output QN

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REAL OUTPUT

PRIC

E LE

VEL

The “Natural” Rate of Output

QN

AS

AD2

AD1

P2

P1

Fluctuations in aggregate demand affect the price level but not real output.

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Short vs. Long-run Perspectives

• The long-run aggregate supply curve is likely to be vertical at QN

• The short-run aggregate supply curve is likely to be upward-sloping

• Both aggregate supply and aggregate demand influence short-run macro outcomes

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Policy Strategies

• Shift the aggregate demand curve: Use policy tools that affect total spending

• Shift the aggregate supply curve: Implement policy levers that influence the costs of production or otherwise affect output

• Laissez-faire: Don’t interfere with the market; let markets self adjust

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Selecting Policy Tools

• There are a host of tools available:– Classical laissez faire– Fiscal policy– Monetary policy– Supply-side policy– Trade policy

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Policy Tools

• The laissez-faire approach requires no tools, as the economy naturally self-adjusts to full employment

• Fiscal policy: The use of government taxes and spending to alter macroeconomic outcomes

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Policy Tools

• Monetary policy: The use of money and credit controls to influence macroeconomic outcomes

• Supply-side policy: The use of tax incentives, (de)regulation, and other mechanisms to increase the ability and willingness to produce goods and services

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Policy Tools

• Trade policy can be used to affect international trade and money flows and shift the aggregate demand and/or the aggregate supply curve