1. 1 FINA 353 Principles of Macroeconomics Lecture 6 Topic: Aggregate Demand Dr. Mazharul Islam

2. 2 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 (Y e ) and Potential output (Y P ) and why and how they will change Dr. Mazharul Islam

3. 3 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. Dr. Mazharul Islam

4. 4 Aggregate Demand Fundamentals  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: o consumption expenditures (C), o investment (I), o government spending (G), and o exports minus imports (net exports), (X – M). That is: Y = C + I + G + (X – M) = GDP (expenditure measure) Dr. Mazharul Islam

5. 5 Aggregate Demand Curve Dr. Mazharul Islam

6. 6 Aggregate Demand Curve - Downward slope. Dr. Mazharul Islam “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 ________ Drops Decrease

7. 7 Aggregate Demand Curve - Downward slope Dr. Mazharul Islam 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 Decrease

8. 8 Aggregate Demand Curve - Downward slope Dr. Mazharul Islam 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

9. 9 Aggregate Demand Curve - Downward slope Dr. Mazharul Islam Real GDP Price Level P3P3 Q3Q3 Q1Q1 Q2Q2 AD P1P1 P2P2 Price level ↑ moves us leftward along the AD curve Price level ↓ moves us rightward along the AD curve

10. 10 Changes in Aggregate Demand. Dr. Mazharul Islam 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 : 1.Expectations about the future (concerning economic, political and social factors) 2.Government Economic Policies (Fiscal and monetary policies) 3.The state of the world economy (net exports)

11. 11 Changes in AD ( ) for expectation Changes in AD (Shift of the AD curve) for expectation 1)Expected higher future income-AD (Rightward) 2) Expected lower future income-AD (Leftward) 3)Expected higher future inflation-AD (Rightward) 4)Expected lower future inflation-AD (Leftward) 5)Expected higher future profits-AD (Rightward) 6)Expected lower future profits-AD (Leftward) Dr. Mazharul Islam With same price level

12. 12 Changes in AD ( ) for government policies Changes in AD (Shift of the AD curve) for government policies 1)Expansionary fiscal policy ( tax,G,TP ) -AD (Rightward) 2)Contractionary fiscal policy (tax,G,TP ) -AD (Leftward) 3)Expansionary monetary policy ( i MS ) - AD (Rightward) 4)Contractionary monetary policy(i MS )-AD (Leftward) Dr. Mazharul Islam With same price level

13. 13 Changes in AD ( ) for state of the world economy Changes in AD (Shift of the AD curve) for state of the world economy 1)Better world economy ( foreign income ) - AD (Rightward) 2)Worse world economy ( foreign income ) - AD (Leftward) 3)Lower exchange rate (X M ) - AD (Leftward) 4)Higher exchange rate (X M ) - AD (Rightward) Dr. Mazharul Islam With same price level

14. 14 Changes in AD ( ) Changes in AD (Shift of the AD curve) Dr. Mazharul Islam Entire AD curve shifts rightward if: a, I, TP, G, or NX increases Net taxes, i decrease The money supply increases AD 2 AD 1 Real GDP Price Level Entire AD curve shifts leftward if: a, I, TP, G, or NX decreases Net taxes, i increase The money supply decrease AD 1 AD 2 Real GDP Price Level

15. 15 Macroeconomic Equilibrium (short-run) Dr. Mazharul Islam  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.

16. 16 Short-Run Equilibrium – Graph Dr. Mazharul Islam AD SAS Short-run macroeconomic equilibrium 0 85 115 95 105 125 860 900 940 880 920 Real GDP Price Level

17. 17 Explaining Macroeconomic Fluctuations Dr. Mazharul Islam – 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.

18. 18 What Happens When Things Change? Dr. Mazharul Islam  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

19. 19 Dr. Mazharul Islam The Effect of a Demand Shock in short-run Price Level Real GDP($ Trillions) 100 130 SAS 10 12.5 13.5 E J H AD 1 AD 2 115

20. 20 An Increase in Government Purchases An Increase in Money Supply

21. 21 Inflationary and Recessionary Gap Dr. Mazharul Islam – 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.

22. 22 Now it’s over for today. Do you have any question? Dr. Mazharul Islam