Aggregate Demand: Introduction and Determinants AP Macro Mr. Warner

Here we go……! This is where differences between A students and C students start. We are going to learn the “AD-AS” macroeconomic model. This is a major part of the AP exam because this model helps us understand various macroeconomic concepts: Recession demand and supply shocks Stagflation the role of productivity why input prices matter, and so much more. AD is 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 world.

Aggregate Demand Aggregate Demand Curve Horizontal axis Vertical axis Relationship between price level and real GDP demanded AD is 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 world.

What you will learn in this Module: How does aggregate demand relate to price level and output? What are the wealth and interest effects? What factors can shift the aggregate demand curve?

Why is the Aggregate Demand Curve Downward Sloping? Macro vs. Micro graphical representations: y-axis Substitution effect What if ALL PRICES change? So, why downward? Students think that the downward slope of the aggregate demand curve is a natural consequence of the law of demand. Since the demand curve for any one good is downward sloping, isn’t it natural that the demand curve for aggregate output is also downward sloping? This is a misleading parallel. The demand curve for any individual good shows how the quantity demanded depends on the price of that good, holding the prices of other goods and services constant.   Example: The demand curve for apples is downward sloping because all else equal, if the price of apples goes up, consumers will switch to a substitute fruit like bananas. With AD, we are talking about the aggregate price level rising for all goods and services in the economy. 1. Wealth or real balances effect: When price level falls, purchasing power of existing financial assets (like money in your savings account) rises, this can increase consumer spending and there is a downward movement along the fixed AD curve. 2. Interest‑rate effect: A decline in price level means lower interest rates which can increase levels of certain types of spending. How does this work? A lower price level increases the purchasing power of money in your pocket so you need to hold less money to buy your goods and services. This decrease in the demand for money holdings puts downward pressure in interest rates. Remind students that we learned that nominal interest rate = real interest rate + expected inflation. If inflation expectations gradually fall, nominal interest rates should also gradually fall. Lower interest rates will increase investment spending, thus increasing real GDP along the AD curve. p’ p Y’ Y

Why is the Aggregate Demand Curve Downward Sloping? 1) Wealth effect We save money as units (1,000 under your bed is still 1,000 years later) If prices in general go down, your 1,000 buys more things. If prices in general go up, you can buy less things. Students think that the downward slope of the aggregate demand curve is a natural consequence of the law of demand. Since the demand curve for any one good is downward sloping, isn’t it natural that the demand curve for aggregate output is also downward sloping? This is a misleading parallel. The demand curve for any individual good shows how the quantity demanded depends on the price of that good, holding the prices of other goods and services constant.   Example: The demand curve for apples is downward sloping because all else equal, if the price of apples goes up, consumers will switch to a substitute fruit like bananas. With AD, we are talking about the aggregate price level rising for all goods and services in the economy. 1. Wealth or real balances effect: When price level falls, purchasing power of existing financial assets (like money in your savings account) rises, this can increase consumer spending and there is a downward movement along the fixed AD curve. 2. Interest‑rate effect: A decline in price level means lower interest rates which can increase levels of certain types of spending. How does this work? A lower price level increases the purchasing power of money in your pocket so you need to hold less money to buy your goods and services. This decrease in the demand for money holdings puts downward pressure in interest rates. Remind students that we learned that nominal interest rate = real interest rate + expected inflation. If inflation expectations gradually fall, nominal interest rates should also gradually fall. Lower interest rates will increase investment spending, thus increasing real GDP along the AD curve.

Why is the Aggregate Demand Curve Downward Sloping? Price Level decreases Lower price level means inflation is going down. If inflation is going down, this means that banks can reduce their nominal interest rates. If nominal interest rates go down, firms will increase their investment spending. An increase in investment spending leads to an increase in consumer spending because money from the firms ends up in households. Price level increases Because inflation reduces purchasing power (wealth effect), in general we have a reduction in consumption, which drives a reduction in investment spending. People and firms hold on more tightly to their money (assuming no hyperinflation), so economic players lose their liquidity. We can say that the demand for money has increased.**** This also applies to banks, who become less willing to loan out money. This drives up the real interest rate, in addition to the increase in expected inflation, leading to a higher overall increase in the nominal interest rate. 2) Interest Rate Effect Students think that the downward slope of the aggregate demand curve is a natural consequence of the law of demand. Since the demand curve for any one good is downward sloping, isn’t it natural that the demand curve for aggregate output is also downward sloping? This is a misleading parallel. The demand curve for any individual good shows how the quantity demanded depends on the price of that good, holding the prices of other goods and services constant.   Example: The demand curve for apples is downward sloping because all else equal, if the price of apples goes up, consumers will switch to a substitute fruit like bananas. With AD, we are talking about the aggregate price level rising for all goods and services in the economy. 1. Wealth or real balances effect: When price level falls, purchasing power of existing financial assets (like money in your savings account) rises, this can increase consumer spending and there is a downward movement along the fixed AD curve. 2. Interest‑rate effect: A decline in price level means lower interest rates which can increase levels of certain types of spending. How does this work? A lower price level increases the purchasing power of money in your pocket so you need to hold less money to buy your goods and services. This decrease in the demand for money holdings puts downward pressure in interest rates. Remind students that we learned that nominal interest rate = real interest rate + expected inflation. If inflation expectations gradually fall, nominal interest rates should also gradually fall. Lower interest rates will increase investment spending, thus increasing real GDP along the AD curve.

Shifts of the Aggregate Demand Curve W.A.G.E. ∆Wealth ∆Adding or Subtracting Inventory ∆Government intervention: Fiscal (tax and G) Monetary Policy (money supply) ∆Expectations: Consumer Confidence Index There are shifts of the aggregate demand curve, changes in the quantity of goods and services demanded at any given price level. An increase in aggregate demand means a shift of the aggregate demand curve to the right, as shown in the figure below. A rightward shift occurs when the quantity of aggregate output demanded increases at any given aggregate price level.   A decrease in aggregate demand means that the AD curve shifts to the left. A leftward shift implies that the quantity of aggregate output demanded falls at any given aggregate price level. Whether AD shifts to the right or to the left, the multiplier effect increases, or decreases, total spending throughout the economy. 1. Changes in Expectations When consumers and firms are more optimistic about their future economic prospects, they will increase consumption and investment spending. This shifts AD to the right. 2. Changes in Wealth We discussed in the last module that the consumption function increased if consumer wealth increased. When the value of accumulated household assets goes up, consumers respond by increasing current consumption. This is one reason why a weak stock market or real estate market has a negative ripple effect in the economy by shifting AD to the left. 3. Size of the Existing Stock of Physical Capital Firms plan to invest in physical capital when the stock is being depleted or is insufficient to meet demand for their products. If firms have plenty of physical capital already, investment spending will slow down. C. Government Policies and Aggregate Demand Note: prepare the students for future chapters on fiscal and monetary policy by getting them to think about how the government can affect AD. Government can have a powerful influence on aggregate demand and that, in some circumstances, this influence can be used to improve economic performance. The two main ways the government can influence the aggregate demand curve are through fiscal policy and monetary policy. 1. Fiscal Policy Congress and the President control fiscal policy. Fiscal policy is the use of either government spending—government purchases of final goods and services and government transfers—or tax policy to stabilize the economy. Suppose the economy was in a recession. The government can intervene directly or indirectly. If the government increases spending (G), it will have a direct impact on AD by shifting AD to the right. If the government decreased taxes, this would increase disposable income, and this would increase consumption spending. The increase in C would shift the AD curve to the right, helping to indirectly reverse the recession. 2. Monetary Policy The Federal Reserve controls monetary policy—the use of changes in the quantity of money or the interest rate to stabilize the economy. This drives the interest rate down at any given aggregate price level, leading to higher investment spending and higher consumer spending. When the Fed increases the quantity of money in circulation, households and firms have more money, which they are willing to lend out. Thus increasing the quantity of money shifts the aggregate demand curve to the right. Note: the students will be exposed in great detail to monetary policy in upcoming chapters of the text.

Movement Along the Curve p’ A decrease in the aggregate price level results in more real GDP being demanded because of the wealth effect and the interest rate effect a lower price level results in more purchasing power for financial assets, so more real GDP is demanded a lower price level also results in a lower nominal interest rate which means that more investment in capital (a component of real GDP ) occurs An increase in the aggregate price level results in less real GDP being demanded because of both the wealth effect and the interest rate effect a higher price level results in less purchasing power for financial assets, so less real GDP is demanded a higher price level also results in a higher nominal interest rate which means that less investment in capital (a component of real GDP ) occurs p p Y’ Y Y

Shocks and slides Homework 4) If the PBOC increases interest rates? Chinese businesses plan for Spring Festival Stocks have been generally raising in value Inflation has been in a slow, steady decline Citizens become afraid that their country may go to war soon 5) Businesses are afraid they might not have enough goods in stock 6) President Xi announces tax cuts for the lower 20% of the population Read Chapter 18 – What shifts SRAS and why is LRAS vertical? 4) If the PBOC increases interest rates? 5) If a housing bubble bursts? 6) If businesses expect slower sales next quarter? What happens to equilibrium at AD if…? Construction firms decide there are already too many apartments in Hangzhou? If a new report comes out showing an unexpected growth in inflation? If the government decides to reduce taxes? There are shifts of the aggregate demand curve, changes in the quantity of goods and services demanded at any given price level. An increase in aggregate demand means a shift of the aggregate demand curve to the right, as shown in the figure below. A rightward shift occurs when the quantity of aggregate output demanded increases at any given aggregate price level.   A decrease in aggregate demand means that the AD curve shifts to the left. A leftward shift implies that the quantity of aggregate output demanded falls at any given aggregate price level. Whether AD shifts to the right or to the left, the multiplier effect increases, or decreases, total spending throughout the economy. 1. Changes in Expectations When consumers and firms are more optimistic about their future economic prospects, they will increase consumption and investment spending. This shifts AD to the right. 2. Changes in Wealth We discussed in the last module that the consumption function increased if consumer wealth increased. When the value of accumulated household assets goes up, consumers respond by increasing current consumption. This is one reason why a weak stock market or real estate market has a negative ripple effect in the economy by shifting AD to the left. 3. Size of the Existing Stock of Physical Capital Firms plan to invest in physical capital when the stock is being depleted or is insufficient to meet demand for their products. If firms have plenty of physical capital already, investment spending will slow down. C. Government Policies and Aggregate Demand Note: prepare the students for future chapters on fiscal and monetary policy by getting them to think about how the government can affect AD. Government can have a powerful influence on aggregate demand and that, in some circumstances, this influence can be used to improve economic performance. The two main ways the government can influence the aggregate demand curve are through fiscal policy and monetary policy. 1. Fiscal Policy Congress and the President control fiscal policy. Fiscal policy is the use of either government spending—government purchases of final goods and services and government transfers—or tax policy to stabilize the economy. Suppose the economy was in a recession. The government can intervene directly or indirectly. If the government increases spending (G), it will have a direct impact on AD by shifting AD to the right. If the government decreased taxes, this would increase disposable income, and this would increase consumption spending. The increase in C would shift the AD curve to the right, helping to indirectly reverse the recession. 2. Monetary Policy The Federal Reserve controls monetary policy—the use of changes in the quantity of money or the interest rate to stabilize the economy. This drives the interest rate down at any given aggregate price level, leading to higher investment spending and higher consumer spending. When the Fed increases the quantity of money in circulation, households and firms have more money, which they are willing to lend out. Thus increasing the quantity of money shifts the aggregate demand curve to the right. Note: the students will be exposed in great detail to monetary policy in upcoming chapters of the text.