Module 17- Aggregate Demand BY J.A.SACCO

C+I+G+(X-M) Let Us Build Our Model! Go Back to GDP The next three modules (17-19) deal with why business activity fluctuates. A way to explain changes in output/unemployment/price level. Go Back to GDP C+I+G+(X-M)

C+I+G+(X-M) Let Us Build Our Model! The components of GDP determine the value of total expenditures. Consumers, Business Capital Investment, Government, Foreign Markets make these spending decisions.

Answered by developing? Let Us Build Our Model! However, this much too simple an explanation. Two issues much be answered. What determines the total amount that individuals, firms, governments, and foreigners want to spend? What determines whether this spending will result in a higher output of goods/services (quantity) or higher prices (inflation)? Aggregate Demand and Aggregate Supply Answered by developing?

Let Us Build Our Model! 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 created at each price level. RDI = RGDP Remember Circular Flow.

The Aggregate Demand Curve AD C As the price level rises, real GDP demanded decreases 140 B Price Level/ GDP Deflator 120 A 100 1 2 3 4 5 6 7 8 9 10 Real GDP per Year ($ trillions)

The Aggregate Demand Curve AD A As the price level falls, real GDP demanded increases 140 B Price Level/GDP Deflator 120 C 100 1 2 3 4 5 6 7 8 9 10 Real GDP per Year ($ trillions)

Houston, We May Have a Problem! Question- Why might the Law of Demand and the reasons for the downward slope of the microeconomic 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.

Review- A Change in the Price Level Direct Effect/Real Balance Effect/Wealth Effect If PL Purchasing Power Rate of Consumption Quantity AD If PL Purchasing Power Rate of Consumption Quantity AD

The Aggregate Demand Curve The Interest Rate Effect- Change in the price level indirectly effects the interest rate. When price level increases, you go out to replace your lost purchasing power. This greater demand for money causes the nominal interest rate to increase. 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.

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 If PL

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 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 Level 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 Level Determinants of Aggregate Demand Any non-price-level change that increases aggregate spending (on domestic goods) shifts AD to the right. A drop in the foreign exchange value of the dollar (weak dollar) Increased security about jobs and future income Improvements in economic conditions in other countries A reduction in real interest rates (nominal interest rates corrected for inflation) not due to price level changes Tax decreases/Increase government spending (fiscal policy) An increase in the amount of money in circulation (monetary policy)

Shifts in the Aggregate Demand Curve Increase in Aggregate Demand AD 120 GDP Deflator 90 AD1 1 2 3 4 5 6 7 Real GDP per Year ($ trillions)

Non-Price Level Determinants of Aggregate Demand Any non-price-level change that decreases aggregate spending (on domestic goods) shifts AD to the left. A rise in the foreign exchange value of the dollar (strong dollar) Decreased security about jobs and future income Declines in economic conditions in other countries A rise in real interest rates (nominal interest rates corrected for inflation) not due to price level changes Tax increases/Decrease government spending (fiscal policy) A decrease in the amount of money in circulation (monetary policy)

Shifts in the Aggregate Demand Curve Decrease in Aggregate Demand AD 120 GDP Deflator 90 AD1 1 2 3 4 5 6 7 Real GDP per Year ($ trillions)

Shifts in the Aggregate Demand Curve For each example determine the changes in the AD curve. The President raises taxes by 10%. The price of domestic automobiles increases by 8%. The stock market experiences new highs for the year. Surveys show that consumers believe that a recession is near. Inflation increases by 5%. Government spending increases by 3 %. Interest rates on savings accounts to an all time low. American exports to Japan increases. Capital good investment decreases this year. Khan Academy- Shifts in AD