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Chapter 7
Aggregate Demand and
Aggregate Supply
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Aggregate Demand
 Aggregate Demand is not same as just Demand
we learnt in chapter 3.
 In chapter 3, Demand was a relationship
between
 Price (P)
 Quantity Demanded at that price (Qd)
 According to the Law of Demand, if you recall,
P and Qd had a negative relationship
 Does anyone remember what that meant?
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The Law of Demand
 The negative relationship means two things:
 When Price
Quantity demanded
 When price
Quantity demanded
Copied from chapter 3
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Aggregate Demand
 Aggregate Demand is also a relationship
between two important macro variables
 Those are:
Its not price (P)
 Price Level (PL)
 Real GDP (Y) It’s not the Quantity Demanded(Qd)
 There is a big difference, here
 One concerns a single good or service (D)
 The concerns the whole economy (AD)
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Difference between P and PL
 Price or P simply means price of any single
good or service. Say price of apple or orange
 Price Level or PL, on the other hand, is the
average price of all goods and services
combined
 PL is typically captured by some sort of price
index
 Can anyone give me an example of a price
index?
Very
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is one,you
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another
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Difference between QD and RGDP
 Again, Quantity Demanded or QD is for a
single good or service.
 RGDP is for the whole economy
 However, there is a similarity
 Both D and AD express a negative relationship
 Which means, they both have
Negative Slope
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Price Level
PL
C +
I +
G +
Xn =
RGDP
A
1.18
8,400
1,820
2,150
-570
11,800
B
1.16
8,450
1,860
2,150
-560
11,900
C
1.14
8,500
1,900
2,150
-550
12,000
D
1.12
8,550
1,940
2,150
-540
12,100
E
1.10
8,600
1,980
2,150
-530
12,200
Price level (base year = 1.00)
Point on AD
curve
1.2
1.18
1.16
1.14
1.12
1.1
Aggregate
Demand (AD)
A
B
C
D
E
1.08
11,600 11,700 11,800 11,900 12,000 12,100 12,200 12,300 12,400 12,500 12,600
Real GDP (billions of base-year dollars) per year
Why AD is Downward Sloping
 When PL rises, RGDP falls and when PL falls
RGDP rises
 This can be explained by following 3 effects:
 Wealth Effect
 Interest Rate Effect
 International Trade Effect
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Wealth Effect
When PL Rises
 Value of saved asset
or wealth (stock,
bonds and savings)
falls
 People feel Poorer
 Consumption (C)
Falls
 RGDP falls
When PL Falls
 Value of saved asset
or wealth (stock,
bonds and savings)
rises
 People feel Richer
 Consumption (C)
Rises
 RGDP Rises
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Interest Rate Effect
When PL Rises
 People demand more
Money
 Interest rate Rises
 Investment (I) Falls
 RGDP falls
 This channel is
known as Interest
Rate Effect
When PL Falls
 People demand
Less Money
 Interest rate Falls
 Investment (I) Rises
 RGDP Rises
 This channel is
known as Interest
Rate Effect
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International Trade Effect
When PL Rises
 Export Falls
 Import Rises
 Net Export (XN) Falls
 RGDP falls
 This channel is
known as
International Trade
Effect
When PL Falls
 Export Rises
 Import Falls
 Net Export (XN) Rises
 RGDP risess
 This channel is
known as
International Trade
Effect
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Price Level
PL
Xn =
RGDP
A
1.18
8,400
1,820
2,150
-570
11,800
B
1.16
8,450
1,860
2,150
-560
11,900
C
1.14
8,500
1,900
2,150
-550
12,000
D
1.12
8,550
1,940
2,150
-540
12,100
E
1.10
8,600
1,980
2,150
-530
12,200
From
A to E
PL is
Falling
C is
Rising
I is
Rising
G is
Unchanged
Xn is
Rising
RGDP is
Rising
Price level (base year = 1.00)
Point on AD
curve
C
+
I
+
G
+
1.2
1.18
1.16
1.14
1.12
1.1
1.08
11,600 11,700 11,800 11,900 12,000 12,100 12,200 12,300 12,400 12,500 12,600
Real GDP (billions of base-year dollars) per year
Change in AD
 Because of Wealth Effect, Interest Rate Effect
and International Trade Effect, when PL
changes, RGDP changes in the Opposite
Direction
 This causes a Movement on a same AD curve
 When some thing other than PL affect the AD,
the whole AD curve shifts.
This is known as Change in AD
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Change in AD
 Note, change in PL will never shift the AD
curve
 But, changes in C, I, G and XN will
 This is because they are all components of
RGDP
 For example, if businesses feel optimistic about
2011 and spend $10b in new investment (I),
then this will increase RGDP at all possible PL
 This means, AD will shift to the right
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Change in AD
Price level (base year = 1.00)
A decrease in aggregate demand
An increase in aggregate demand
1.2
1.18
1.16
1.14
1.12
1.1
AD2
AD1
AD2
1.08
Real GDP (billions of base-year dollars) per year
Idea of Multiplier
 Because of initial investment of $10b, RGDP
will Directly rise by $10b almost immediately
 However, there are Indirect boost to economy
as well
 Recall, someone spending is always someone
else’s income
 Investment spending will also increase incomes
and wages in the economy
 With higher income, consumption (C) will rise
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Idea of Multiplier
 Increased Consumption (c) will further
increase the RGDP
 But, Cycle does not stop there.
 Because of consumption spending, someone
else’s income rises and induces more
consumption by the person whose income has
rises
 When all is over, economy observes a much
larger increase than initial investment
spending.
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Idea of Multiplier
 Multiplier measures, how many times the final
RGDP rises compared to initial spending
 Formula:
Multiplier =
Change in Final RGDP
Change in Initial Component of AD
Exercise: if $10b investment increases the RGDP
by $25b, compute the multiplier
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The Multiplier
Panel (a)
Price level (base year = 1.00)
1.2
1.18
1.16
Effect of initial increase in net
exports without multiplier
effect
1.14
1.12
1.1
AD1
AD2
1.08
Real GDP (billions of base-year dollars) per year
The Multiplier
Panel (b)
Price level (base year = 1.00)
1.2
1.18
Effect of initial decrease in net
exports without multiplier
effect
1.16
1.14
1.12
1.1
AD2
AD1
1.08
Real GDP (billions of base-year dollars) per year