Unit III: Aggregate Demand

Aggregate Demand Curve

-AD is the demand by consumers, businesses, government, and foreign countries

 -What definitely doesn’t shift the curve: changes in price cause a move along the curve

-AD= C+I+G+Xn

- GDPR is Real domestic output

-Why is AD downward sloping?

        I.            Real-Balance Effect

                                i.            High price level reduces the purchasing power of money

                              ii.            This decreases the quantity of expenditures

                            iii.            Lowers price level increases purchasing power, increases expenditures

                            iv.            Example: $50,000 in a bank account during inflation erodes purchasing power, likely to reduce spending

      II.            Interest Rate Effect

                                i.            When the price level increases, lenders need to charge higher interest rates to get a real return on their loans

                              ii.            Higher interest rate discourages consumer spending and business investment

                            iii.            Example: An increase in interest rate causes 5% to 25% less likely to take out loans to improve your business

   III.        III. Foreign Trade Effect

                                i.            U.S. price level increases cause foreign buyers to purchase fewer U.S. goods, Americans buy more foreign goods.

                              ii.            Exports decreases, imports increases, causing real GDP to fall (Xn decreases)

Shifters of Aggregate Demand

-Shifts in AD caused by a change in C, Ig, G, and/or Xn

-Multiplier effect that produces a greater change than the original change in four components

-Increases in AD shifts AD ->

-Decreases in AD shifts AD <-

Determinants of AD

I.                    Consumption: household spending is affected by consumer wealth

        i.            More wealth= more spending (AD →)

      ii.            Less wealth= less spending (AD ←)

II.                  Consumer expectations:

                                            i.            Positive expectation=more spending (AD →)

                                          ii.            Negative expectations=less spending (AD ←)

III.               Household indebtedness 

i.                    Less debt= more spending (AD →)

ii.                  More debt= less spending (AD ←)

IV.               Taxes

i.                    Less taxes= more spending (AD →)

ii.                  More taxes= less spending (AD ←)

Gross Private Domestic Investment

Investment spending is sensitive to        

I.                    Real interest rate

                                                        i.            Lower real interest rate= more investment AD →

                                                      ii.            Higher interest rate = less investment AD ← 

II.                  Expected returns

i.                    Higher expected returns= more investment AD →

                                                    iii.            Lower expected returns= less investment AD ← 

Expected returns are influenced by

I.                    Expectations of future profitability

II.                  Technology

III.               Degree of excess capacity (existing stock of capital)

IV.               Business taxes

Government Spending

-More government spending= AD →

-Less government spending= AD ←

Net exports are sensitive to exchange rates (international value of $)

-Strong $= more exports and fewer exports AD →

-Weak $= fewer imports and more exports AD ←

Relative Income

-Strong foreign economy= more exports AD →

-Weak foreign economy= less exports AD ←