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Ch.10- Aggregate Demand/Aggregate Supply. BY J.A.SACCO. Let Us Build Our Model!. Chapter deals with why business activity fluctuates. A way to explain changes in output/unemployment/price level. Go Back to GDP. C+I+G+(X-M). Let Us Build Our Model!. C+I+G +(X-M).

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let us build our model
Let Us Build Our Model!
  • Chapter deals with why business activity fluctuates. A way to explain changes in output/unemployment/price level.

Go Back to GDP

C+I+G+(X-M)

let us build our model1
Let Us Build Our Model!

C+I+G+(X-M)

The components of GDP determine the value of total

expenditures. Consumers, Business Capital Investment,

Government, Foreign Markets make these spending decisions.

let us build our model2
Let Us Build Our Model!
  • However, this much to 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 model3
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
  • 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 demand1
Aggregate Demand

C+I+G+(X-M)

Furthermore, AD Curve gives the total amount of Real Domestic Income (RDI) that will be purchased at each price level.

RDI = RGDP

Remember Circular Flow.

the aggregate demand curve

C

As the price level

rises, real GDP

demanded declines

B

A

AD

The Aggregate Demand Curve

140

Price Level/ GDP Deflator

120

100

0

1

2

3

4

5

6

7

8

9

10

Real GDP per Year

($ trillions)

the aggregate demand curve1

A

As the price level

falls, real GDP

demanded increases

B

C

AD

The Aggregate Demand Curve

140

120

Price Level/GDP Deflator

100

0

1

2

3

4

5

6

7

8

9

10

Real GDP per Year

($ trillions)

houston we may have a problem
Houston, We May Have a Problem!
  • Question- Why might the Law of Demand and the reasons for the downward slope of the demand curve not be applicable with aggregate demand.
  • Law of Demand (one good/service) states

Pr

QD

Pr

QD

houston we may have a problem1
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
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 curve2
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.
the aggregate demand curve3
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.

the aggregate demand curve4
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
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

review a change in the price level1
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

Nominal Interest Rate

Consumption/ Investment

Quantity AD

If PL

review a change in the price level2
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 level3
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 determinants of aggregate demand
Non- Price 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 determinants of aggregate demand1
Non- Price 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
  • 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 (Fiscal Policy)
  • An increase in the amount of money in circulation (Monetary Policy)
shifts in the aggregate demand curve

AD

Shifts in the Aggregate Demand Curve

Increase in

Aggregate

Demand

120

GDP Deflator

90

AD1

0

1

2

3

4

5

6

7

Real GDP per Year

($ trillions)

determinants of aggregate demand
Determinants ofAggregate 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
  • 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 (Fiscal Policy)
  • An decrease in the amount of money in circulation (Monetary Policy)
shifts in the aggregate demand curve1

AD

Shifts in theAggregate Demand Curve

Decrease in

Aggregate

Demand

120

GDP Deflator

90

AD1

0

1

2

3

4

5

6

7

Real GDP per Year

($ trillions)