module 17 aggregate demand

AGGREGATE DEMAND:

INTRODUCTION AND DETERMINANTS

MODULE 17

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AGGREGATE DEMAND

• The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, the government, and the rest of the world.

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AGGREGATE DEMAND

• The horizontal axis shows the total quantity of domestic goods and services demanded, measured in real dollars.

• Real GDP is used to measure aggregate output and either term can be used.

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AGGREGATE DEMAND

• The vertical axis shows the aggregate price level, measured by the GDP deflator.

• The AD (aggregate demand) curve shows how much aggregate output would be demanded at any given price level.

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AGGREGATE DEMAND

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AGGREGATE DEMAND• The aggregate demand curve is

downward sloping, indicating a negative relationship between the aggregate price level and the quantity of aggregate output demanded.

• A higher aggregate price level reduces the quantity of aggregate output demanded; a lower aggregate price level increases the quantity of aggregate output demanded.

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AGGREGATE DEMAND

1. It shows an inverse relationship between price level and domestic output.

2. The explanation of the inverse relationship is not the same as for demand for a single product, which centered on substitution and income effects.

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AGGREGATE DEMAND

a. Substitution effect doesn’t apply in the aggregate case, since there is no substitute for “everything.”

b. Income effect also doesn’t apply in the aggregate case, since income now varies with aggregate output.

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AGGREGATE DEMAND

• The Law of Demand does not explain why the AD curve is downward sloping.

• When we consider movements up or down the AD curve, we are considering a simultaneous change in the prices of all final goods and services.

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WHY IS AGGREGATE DEMAND DOWNSLOPING?

There are two main reasons why a rise in the aggregate price level leads to a fall in the quantity of all domestically produced final goods and services demanded:1. The Wealth Effect: The change in

consumer spending caused by the altered purchasing power of consumer’s assets.

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WHY IS AGGREGATE DEMAND DOWNSLOPING?

• An increase is the aggregate price level, other things equal, reduces the purchasing power of many assets, leading to a fall in spending on final goods and services, because a rise in the aggregate price level reduces the purchasing power of everyone.

• Correspondingly, a fall in the aggregate price level increases the purchasing power of consumer’s assets and leads to more consumer demand.

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WHY IS AGGREGATE DEMAND DOWNSLOPING?

• So the wealth effect of a change in the aggregate price level causes consumer spending to fall when the aggregate price level rises and to rise when the aggregate price level falls.

• This leads to a downward sloping aggregate demand curve.

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WHY IS AGGREGATE DEMAND DOWNSLOPING?

2. The Interest Rate Effect: People and firms hold money because it reduces the cost and inconvenience of making transactions.

• When the aggregate price level increases, other things equal, this reduces the purchasing power of the money holdings, so people need to hold more money to be able to purchase the same basket of goods and services as before.

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WHY IS AGGREGATE DEMAND DOWNSLOPING?

• So, the public tries to increase their holding of money by borrowing or by selling assets such as bonds.

• This reduces the amount of funds available for lending to other borrowers and drives the interest rates up.

• A rise in the interest rate reduces investment spending because it makes the cost of borrowing higher and reduces consumer spending because households will now save more of their disposable income.

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WHY IS AGGREGATE DEMAND DOWNSLOPING?

• So a rise in the aggregate price level depresses investment spending, I, and consumer spending, C, through its effect on the purchasing power of money holdings, through the effect of the interest rate effect of a change in the aggregate price level.

• This leads to a downward sloping aggregate demand curve.

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WHY IS AGGREGATE DEMAND DOWNSLOPING?

3. Foreign purchases effect: When price level falls, other things being equal, U.S. prices will fall relative to foreign prices, which will tend to increase spending on U.S. exports and also decrease import spending in favor of U.S. products that compete with imports.

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DETERMINANTS OF AGGREGATE DEMAND

• A movement along the aggregate demand curve is a change in the quantity of goods and services demanded at any given price level.

• When aggregate demand changes, this is shown as a shift in the aggregate demand curve.

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DETERMINANTS OF AGGREGATE DEMAND

• An increase in aggregate demand, means a shift of the aggregate demand curve to the right.

• This rightward shift occurs when the quantity of aggregate output demanded increases at any aggregate price level.

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DETERMINANTS OF AGGREGATE DEMAND

• A decrease in aggregate demand means a shift of the aggregate demand curve to the left.

• This leftward shift occurs when the quantity of aggregate output demanded decreases at any aggregate price level.

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DETERMINANTS OF AGGREGATE DEMAND

• The most important factors that can shift the aggregate demand curve are:

1. Changes in expectations2. Changes in wealth3. Size of the existing stock of

physical capital4. Fiscal policy5. Monetary policy• All five factors set the multiplier

process in motion.

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DETERMINANTS OF AGGREGATE DEMAND

Initial rise or fall in real GDP

Change disposable income

Additional changes in consumer spending

Further changes in real GDP

…and so on…

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FACTORS THAT SHIFT THE AGGREGATE DEMAND CURVE

• If consumers and firms become more optimistic, AD increases• If consumers and firms become more pessimistic, AD decreases.

Changes in Expectations

• If the real value of household assets rises, AD increases• If the real value of household assets falls, AD decreasesChanges in Wealth

• If the existing stock of physical capital is relatively small, AD increases

• If the existing stock of physical capital is relatively large, AD decreases

Size of the Existing Stock of Physical

Capital

• If government increases spending or cuts taxes, AD increases• If government reduces spending or raises taxes, AD decreasesFiscal Policy

• If the central bank increases the quantity of money, AD increases• If the central bank reduces the quantity of money, AD decreasesMonetary Policy

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FISCAL POLICY• Fiscal Policy is the use of

government spending or tax policy to stabilize the economy.

• Government will respond to recessions by increasing government purchases of final goods and services or by cutting taxes, or both.

• They respond to inflation by reducing their spending or by increasing taxes, or both.

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FISCAL POLICY• The effect government purchases of

final goods and services, G, on the aggregate demand curve is direct because G is a component of aggregate demand.

• The effect of changes in tax rates or government transfers on aggregate demand is indirect through their effect on disposable income. (higher taxes reduce DI and lower taxes increase DI)

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MONETARY POLICY• Monetary Policy is the central

bank’s use of changes in the quantity of money or the interest rate to stabilize the economy.

• Increasing the amount of money reduces the interest rate and boost aggregate demand.

• Decreasing the amount of money increases the interest rate and depresses aggregate demand.