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 How does demand and supply change when things happen in the economy, like:  Inflation  Unemployment  Levels of spending  Real output  We look at.

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Presentation on theme: " How does demand and supply change when things happen in the economy, like:  Inflation  Unemployment  Levels of spending  Real output  We look at."— Presentation transcript:

1  How does demand and supply change when things happen in the economy, like:  Inflation  Unemployment  Levels of spending  Real output  We look at a concept called Aggregate Demand (AD): concept of demand applied to the economy as a whole to see the relationship between general price level and total spending 10.1 Aggregate Demand

2  Recall: total spending on goods & services in an economy:  Consumption  Investment  Government Purchases  Net Exports  The primary groups responsible for this spending are:  Households  Businesses  Governments  Rest of the World  Total spending in an economy: Real Expenditures Aggregate Demand

3  As the general level of prices increases, less real output is bought for two reasons:  1. The real value of financial assets, such as bank accounts and bonds, decreases. Households feel less wealthy, reduce consumption spending  2. Net export spending is reduced, as both foreigners spend less on Canadian exports and Canadian residents spend more on imports  Y-Axis: Price Level = GDP Deflator  X-Axis: Real GDP The Aggregate Demand Curve

4  Recall: price and quantity demanded of a product have an inverse relationship  Same can be said for general price level and real expenditures, but for different reasons:  Quantity demanded explained using law of diminishing marginal utility  Amount spent in economy explained using wealth and foreign trade effects The Aggregate Demand Curve

5 Wealth Effect

6  Changes in price level also influence foreign trade  When price level in Canada rises, Canadian exports become more expensive for foreigners  Decrease in export expenditures  Products imported into Canada become cheaper than domestic products  Foreign Trade Effect: involves a decrease in exports (X – M), thus, a decline in real expenditures Foreign Trade Effect

7  Recall: price level influences total spending (one factor)  Aggregate Demand Factors: change in total spending at all price levels – i.e. aggregate demand curve gets shifted  e.g. Government purchases increase, aggregate demand curve shifts right by amount (Y2 – Y1): Increase in Aggregate Demand  Decrease in a component of real expenditures causes a decrease in aggregate demand (curve shifts left) Changes in Aggregate Demand

8  Factors can be categorized according to the spending component they immediately affect  Consumption – Disposable Income (DI) & Wealth  Most significant determinant of consumer spending is DI  DI and consumption have a direct relationship  A change in stocks will change wealth, which changes consumption  This changes aggregate demand depending on a loss/gain (i.e. value of assets increases or debt increases) Aggregate Demand Factors: Consumption

9  More consumption factors: Consumer expectation and interest rates  Consumer Expectations: if consumers expect prices to rise (e.g. due to a flood), or if they expect their income to rise they will spend more now and save less  Higher consumer spending = aggregate demand increases = aggregate demand curve shifts to the right  Interest Rates: For purchasing big-ticket items, such as cars or furniture, households often buy this on credit  The lower the interest rate = more borrowing for these items  The higher the interest rate = consumer spending falls Aggregate Demand Factors: Consumption

10  Investment: spending on a project where earning a profit is anticipated  For a business to decide whether or not to make an investment, they must calculate:  All expected revenues and costs of project  Calculate project’s real rate of return – constant-dollar extra profit provided by the project each year  A project is only undertaken, if annual benefit > annual cost  Now let’s look at the economy, and not just one business Aggregate Demand Factors: Investment

11  As real interest rate decreases, more investment projects are undertaken  If interest rate is 8%, only project A is carried out  If interest rate is 6%, project B can be pursued as well  Interest rates and investment have an inverse relationship  Even business expectations can affect position of demand curve – what the business anticipates will happen  Investment Demand: the relationship between interest rates and investment  Investment Demand Graph: ID on a graph Aggregate Demand Factors: Investment

12  Rise in Gov’t purchases (e.g. highway construction) = increase in aggregate demand; fall in Gov’t purchases: decrease in AD Aggregate Demand Factors: Government Purchases

13  Price level changes influence total spending in the economy  Expressed as a movement along the aggregate demand curve  Things that cause a change in aggregate demand:  Foreign countries & foreign exchange rates  The effects of changes in these factors is represented by a shift in the aggregate demand curve  If Foreign Incomes rise, other countries will import more items from Canada, increasing Canada’s aggregate demand  If Exchange Rate changes, (e.g. Canadian dollar increases), foreign countries will most likely import less items because they will be more expensive Aggregate Demand Factors: Net Exports

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