Download Aggregate Demand

Aggregate Demand
Introduction & Determinants
• A negative demand shock to the economy as a
whole is a leftward shift of the aggregate
demand curve
• 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
Aggregate Demand
• Aggregate demand curve is downward
sloping, meaning a negative relationship
between the aggregate price level and the
quantity of aggregate output demanded
Aggregate Demand
• Higher aggregate price level, other things
equal, reduces the quantity of aggregate
output demanded
• Lower aggregate price level, other things
equal, increases the quantity of aggregate
output demanded
Aggregate Demand
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GDP = C + I + G + X – IM
C = consumer spending
I = investment spending
G = government purchases of goods and
services
• X = exports to other countries
• IM = imports
Why is the Aggregate Demand
Curve Downward Sloping?
• C + I + G + X – IM is the quantity of
domestically produced final goods and
services demanded during a given period
• G is decided by the government
• Other variables are private-sector decisions
Why is the Aggregate Demand
Curve Downward Sloping?
• Does not slope downward due to the law of demand
• Movements up or down the aggregate demand curve
are a simultaneous change in the prices of all final
goods and services
• Goods and services in consumer spending aren’t
relevant to the aggregate demand curve
• If consumers decide to buy fewer clothes but more cars,
this doesn’t change the total quantity of final goods and
services they demand
Why is the Aggregate Demand
Curve Downward Sloping?
• Why does a rise in aggregate price level
lead to a fall in the quantity of all
domestically produced final goods and
serviced demanded?
• Wealth Effect
• Interest Rate Effect
Why is the Aggregate Demand
Curve Downward Sloping?
• Increase in the aggregate price level, other
things equal, reduces the purchasing power of
many assets
• Ex: $5,000 in bank account
• Aggregate price level rise by 25%
• $5,000 would buy only as much as $4,000 would
have previously bought
• Less money, loss of purchasing power
The Wealth Effect
• A fall in the aggregate price level increases the
purchasing power of consumers’ assets and
leads to more consumer demand
• Wealth effect of a change in the aggregate
price level is the change in consumer spending
caused by the altered purchasing power of
consumers’ assets
• Due to wealth effect, consumer spending, C,
falls when the aggregate price level rises –
leading to a downward-sloping aggregate
demand curve
The Wealth Effect
• Money = cash and bank deposits on which
people can write checks
• People and firms hold money because it
reduces the cost and inconvenience of making
transactions
• Increase in the aggregate price level, other
things equal, reduces the purchasing power of
a given amount of money holdings
• Basket of goods and services requires people and
firms to pay more money
The Interest Rate Effect
• Aggregate price level increase leads to the
public increasing its money holdings
• Borrowing or selling assets
• Reduces the funds available for lending to other
borrowers and drive interest rates up
• Rise in interest rate reduces investment spending
because it makes the cost of borrowing higher
• Rise in interest rate also reduces consumer
spending
The Interest Rate Effect
• A rise in aggregate price level depresses
investment spending, I, and consumer
spending, C, through its effect on the
purchasing power of money holdings
• Interest rate effect of a change in the
aggregate price level is the change in
investment and consumer spending caused by
altered interest rates that result from changes
in the demand for money
The Interest Rate Effect
• The aggregate demand curve shifts because of:
• changes in expectations
• wealth
• the stock of physical capital
• government policies
• fiscal policy
• monetary policy
• All five factors set the multiplier process in
motion
Shifts of the Aggregate
Demand Curve
•If consumers and firms become more optimistic, . . . . . .
aggregate demand increases.
•If consumers and firms become more pessimistic, . . . . .
. aggregate demand decreases.
Changes in Expectations
•If the real value of household assets rises, . . . . . .
aggregate demand increases.
•If the real value of household assets falls, . . . . . .
aggregate demand decreases.
Changes in Wealth
•If the existing stock of physical capital is relatively
small, .. aggregate demand increases.
•If the existing stock of physical capital is relatively
large, ..aggregate demand decreases.
Change in Stock of
Physical Capital
•Fiscal policy is the use of taxes, government transfers,
or government purchases of goods and services to
stabilize the economy
•If the government increases spending or cuts taxes, . . .
.. aggregate demand increases.
•If the government reduces spending or raises taxes, . . .
. aggregate demand decreases.
Fiscal Policy
•Monetary policy is the central bank’s use of changes in
the quantity of money or the interest rate to stabilize the
economy
•If the central bank increases the quantity of money, . .. .
. aggregate demand increases.
•If the central bank reduces the quantity of money, . . . . .
. aggregate demand decrease
Monetary Policy