Unit Three: Aggregate Demand

Goals Set up an AD/AS graph with the correct axis Explain why the aggregate demand curve is downward sloping and how that differs from the Law of Demand. Identify and explain the reasons for shifts in aggregate demand and illustrate how that would appear on an AD/AS graph.

I. Setting Up the AD/AS Graph Aggregate Demand Curve: A curve that shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, firms, the government, and the rest of the work.

I. Setting Up the AD/AS Graph Difference between Aggregate Demand and Demand: Demand focuses on one product, that consumers may choose to forgo in exchange for another good. Aggregate demand focuses on all goods and services demanded in an economy, therefore substitution should not cause a change in aggregate quantity demanded.

I. Setting Up the AD/AS Graph The Wealth Effect A rise in aggregate price level, reduces the purchasing power of money. Causes changes to consumer spending and thus aggregate demand. The Interest Rate Effect The interest rate effect is impacted by the change in money supply. A change in the price level will result in a change in borrowing and lending, a change in interest rates, and finally a change in consumption and investment.

I. Setting Up the AD/AS Graph An increase in price level. People will need to borrow more money. Higher interest rates for loans. Businesses are less likely to take out loans for investment. Consumers are more likely to save money and spend less. Decrease in quantity of aggregate output demanded.

II. Shifts in Aggregate Demand Change in Aggregate Demand: Changes in Expectations Changes in Wealth Size of Existing Stock of Physical Capital Fiscal Policy Monetary Policy

II. Shifts in Aggregate Demand Changes in Expectations: Consumer spending and planned investment spending depend in part on expectations about the future. Consumers will make decisions based upon income they EXPECT to make. Producers will make decisions based upon sales they EXPECT to make.

II. Shifts in Aggregate Demand Changes in Wealth: Consumer spending is dictated in part on the value of their assets outside of money easily attainable. For example, investments made by households such as stocks and real estate.

II. Shifts in Aggregate Demand Size of Existing Stock of Capital Size of inventories will dictate how much producers need to invest.

II. Shifts in Aggregate Demand Fiscal Policy Defined: The use of either government spending--- government purchases of final goods and services and government transfers– or tax policy to stabilize the economy. They can have a direct impact from government spending. Or they can have an indirect impact from taxation.

II. Shifts in Aggregate Demand Monetary Policy Defined: the use of changes in the quantity of money or the interest rate to stabilize the economy. An increase in the money supply will make money easier to come by, decreasing the interest rate, and increasing investment.

III. Practice 1)Which of the following explains the slope of the aggregate demand curve? The wealth effect of a change in the aggregate price level The interest rate effect of a change in the aggregate price level The product-substitution effect of a change in the aggregate price level I only II only III only I and II only I, II, and III D

III. Practice 2) Which of the following will shift the aggregate demand curve to the right? A decrease in wealth Pessimistic consumer expectations A decrease in the existing stock of a capital Contractionary fiscal policy A decrease in the quantity of money C

III. Practice 3) Decreases in the stock market decrease aggregate demand by decreasing which of the following? Consumer wealth The price level The stock of existing physical capital Interest rates Tax revenues A

III. Practice 4) Which of the following government policies will shift the aggregate demand curve to the left? A decrease in the quantity of money An increase in government purchases of goods and services A decrease in taxes A decrease in interest rates An increase in government transfers A

III. Practice 5) Draw a correctly labeled graph showing aggregate demand. On your graph from part a, illustrate an increase in aggregate demand. List the four factors that shift aggregate demand. Describe a change in each determinant of aggregate demand that would lead to the shift you illustrated in part b.