Unit 3 Notes - Aggregate Demand

What is Aggregate Demand?

·      The demand by consumers, businesses, government, and foreign countries

·      Changes in price level cause a move along the curve not a shift of the curve

·      Shows the amount of Real GDP that the private, public and foreign sector collectively desire to purchase at each possible price level

·      The relationship between the price level and the level of Real GDP is inverse

·      3 Reasons why AD is downward sloping

1.     Wealth Effect

·       Higher prices reduce purchasing power of $

·      This decreases the quantity of expenditures

·      Lower price levels increase purchasing power and increase expenditures

·      If the balance in your bank was $50,000 but inflation erodes your purchasing power, you will likely reduce your spending

·      So, Price level goes up and GDP demand goes down

2.     Interest-Rate Effect

·      As price level increases, lenders need to charge higher interest rates to get a REAL return on their loans

·      Higher interest rates discourage consumer spending and business investment

·      Ex: Increase in prices leads to an increase in the interest rate from 5% to 25%. You are less likely to take out loans to improve your business

3.     Foreign Trade Effect

·      When U.S price level rises, foreign buyers purchase few goods and Americans buy more foreign goods

·      Exports fall and imports rise causing real GDP demanded to fall. (Xn Decreases)

·      Ex: If prices triple in the US, Canada will no longer buy US Goods causing quantity demanded of US products to fall

-       Shifts in Aggregate Demand (AD)

·      There are two parts to a shift in AD:

1.     A change in C, Ig, G and/or Xn

2.     A multiplier effect that produces a greater change than the original change in the 4 components

·      Increases in AD = AD shifts to the right

·      Decreased in AD = AD shifts to the left

-       Determinants of AD

1.     Consumption (C)

2.     Gross Private Investment (Ig)

3.     Government Spending (G)

4.     Next Exports (Xn)

1.     Change in Consumer Spending

·      Consumer Wealth (Boom in the stock market…)

·      Consumer Expectations (People fear a recession…)

·      Household Indebtedness (More consumer debt…)

·      Taxes (Decrease in income taxes…)

2.     Changes in Investment Spending

·      Real Interest Rates (Price of Borrowing $)

·      (If interest rates increase...)(If interest rates decrease...)

·      Future Business Expectations (High Expectations…)

·      Productivity and Technology (New robots…)

·      Business Taxes (Higher corporate taxes means…)

3.     Changes in Government Spending

·      (War…)

·      (Nationalized Health Care…)

·      (Decrease in Defense Spending…)

4.     Change in Net Exports (X-M)

·      Exchange Rates (If the dollar depreciates relative to the euro)

·      National Income Compared to Abroad (If a major importer has a recession…)

·      If the US has a recession

·      (If the US gets a cold, Canada will get pneumonia)

*AD = GDP = C + Ig + G + Xn

-       Government Spending

·      More Government Spending (AD shifts to the right)

·      Less Government Spending (AD shifts to the left)