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Exploring Economics
Second Edition
by Robert L. Sexton
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Chapter 20
Aggregate Demand
Copyright © 2002 by Thomson Learning, Inc.
20.1 Consumption: The Determinant
of Aggregate Demand

Aggregate Demand (AD) is the sum of
the demand for all goods and services
in the economy. It can also be seen as
the quantity of real GDP demanded at
different price levels.

Aggregate Demand (AD) =
Consumption (C) + Investment (I) +
Government purchases (G) +
Net Exports (X – M).
Copyright © 2002 by Thomson Learning, Inc.
20.1 Consumption: The Determinant
of Aggregate Demand


Consumption is by far the largest
component of AD, typically almost 70
percent of total economic activity,
measured by GDP.
Understanding the determinants of
consumption is critical to an
understanding of the forces leading to
changes in aggregate demand, which in
turn, change total output and income.
Copyright © 2002 by Thomson Learning, Inc.
20.1 Consumption: The Determinant
of Aggregate Demand



The higher a nation’s income, the more
it spends on consumption.
For individuals, consumption increases
with after-tax, or disposable, income.
Consumption is also influenced by other
factors.


the “lumpiness” of some goods’ purchases,
such as cars
interest rates

At higher real interest rates, consumers save
more and consume less.
Copyright © 2002 by Thomson Learning, Inc.
20.1 Consumption: The Determinant
of Aggregate Demand

Milton Friedman’s permanent income
hypothesis


Consumption is related to permanent
income rather than to current income
levels.
Explains such things as why college
students and the elderly often dissave and
farmers’ consumption and saving patterns
through good and bad years.
Copyright © 2002 by Thomson Learning, Inc.
20.1 Consumption: The Determinant
of Aggregate Demand


Looking at the economy as a whole, we
have many groups of people with many
different expectations (for present
versus lifetime incomes).
So for the economy as a whole,
consumption is closely related to current
income.
Copyright © 2002 by Thomson Learning, Inc.
20.1 Consumption: The Determinant
of Aggregate Demand


Households typically spend a large
portion of their total disposable income,
and save the rest.
Average propensity to consume (APC)


the fraction of total disposable income that
households spend on consumption
Marginal propensity to consume (MPC)

the additional consumption that results
from an additional dollar of disposable
income
Copyright © 2002 by Thomson Learning, Inc.
20.2 Investment and Saving Market


If we put the investment demand for the
whole economy and national savings
together, we can establish the real
interest rate in the saving and
investment market.
The investment demand curve (ID) is
downward sloping, reflecting the fact
that investment spending varies
inversely with the real interest rate—the
amount borrowers pay for their loans.
Copyright © 2002 by Thomson Learning, Inc.
20.2 Investment and Saving Market


At high real interest rates, firms will only
pursue those few investment activities
with even higher expected rates of
return.
As the real interest rate falls, additional
projects with lower expected rates of
return become profitable for firms, and
the quantity of investment demanded
rises.
Copyright © 2002 by Thomson Learning, Inc.
20.2 Investment and Saving Market


The investment demand curve shows
the dollar amount of investment
forthcoming at different real interest
rate.
Because lower interest rates stimulate
the quantity of investment demanded,
governments often try to combat
recessions by lowering interest rates.
Copyright © 2002 by Thomson Learning, Inc.
Real Interest Rates, r
(expected rate of return)
The Investment Demand Curve
r1
r0
r2
B
A  B An increase in the real
interest rate will lower the quantity
of investment demanded
A  C A decrease in the real
interest rate will raise the quantity
of investment demanded
A
C
ID
0
Q1 Q0 Q2
Quantity of Investment
(billions of dollars)
Copyright © 2002 by Thomson Learning, Inc.
20.2 Investment and Saving Market

For a given interest rate,


If firms expect higher rates of return on
their investments, the ID curve will shift to
the right.
If firms expect lower rates of return on their
investments, the ID curve will shift to the
left.
Copyright © 2002 by Thomson Learning, Inc.
20.2 Investment and Saving Market

Several determinants other than interest
rates will shift the investment demand
curve.





technology
inventory
expectations
business taxes
the supply of national savings
Copyright © 2002 by Thomson Learning, Inc.
20.2 Investment and Saving Market

Product and process innovation can
cause the ID curve to shift out.

The development of new machines that
can improve the quality and the quantity of
products or lower the costs of production
will increase the rate of return on
investment, independent of the interest
rate. The same is true for new products.
Copyright © 2002 by Thomson Learning, Inc.
20.2 Investment and Saving Market

Inventories are high.


goods are stockpiled in warehouses
lower expected rate of return on new
investment,


Firms with excess inventories of finished goods
have little incentive to invest in new capital.
so ID shifts to the left.
Copyright © 2002 by Thomson Learning, Inc.
20.2 Investment and Saving Market

Inventories are low.



firms look to replenish their shelves
expected rate of return on new investment
increases
so ID shifts to the right.
Copyright © 2002 by Thomson Learning, Inc.
20.2 Investment and Saving Market

If higher expected sales and a higher
profit rate are forecast, firms will invest
in plant and equipment and the ID curve
shifts to the right.


More investment will be desired at a given
interest rate.
If lower expected sales and a lower
profit rate are forecasted, the ID curve
shifts to the left.

Fewer investments will be desired at a
given interest rate.
Copyright © 2002 by Thomson Learning, Inc.
20.2 Investment and Saving Market

If business taxes are lowered, potential
after-tax profits on investment projects
will increase and shift the ID curve to
the right.


such as with an investment tax credit,
Higher business taxes will lead to lower
potential after-tax profits on investment
projects and shift the ID curve to the
left.
Copyright © 2002 by Thomson Learning, Inc.
Real Interest Rates, r
(expected rate of return)
Shifts in the Investment Demand Curve
A  B An increase
in the expected
profit rate
C
A
ID2
0
Q2
B
ID0
Q0
A  C A decrease
in the expected
profit rate
ID1
Q1
Quantity of Investment
(billions of dollars)
Copyright © 2002 by Thomson Learning, Inc.
20.2 Investment and Saving Market

The supply of national saving is
composed of both private saving and
public saving.



Households, firms, and the government
can supply savings.
The supply curve of savings is upward
sloping.
At a higher real interest rate, there is a
greater quantity of savings supplied.
Copyright © 2002 by Thomson Learning, Inc.
20.2 Investment and Saving Market


Think of the interest rate as the reward
for saving and supplying funds to
financial markets.
At a lower real interest rate, a lower
quantity of savings is supplied.
Copyright © 2002 by Thomson Learning, Inc.
Real Interest Rates, r
A Saving Supply Curve
Saving
Supply (SS)
B
r1
A
r0
r2
0
A  C A decrease
in the real interest
rate decreases saving.
C
Q2
Q0
A  B An increase
in the real interest
rate increases saving.
Q1
Quantity of Saving
(billions of dollars)
Copyright © 2002 by Thomson Learning, Inc.
20.2 Investment and Saving Market

If disposable (after-tax) income


rises, the supply of savings shifts to the
right; more savings would occur at any
given interest rate.
falls, the supply of savings shifts to the left;
less saving would occur at any given
interest rate.
Copyright © 2002 by Thomson Learning, Inc.
20.2 Investment and Saving Market


As with the investment demand curve,
there are noninterest determinants of
the saving supply curve.
Expected future earnings


lower, you would tend to save more now at
any given interest rate shifting the saving
supply curve to the right.
higher, you would tend to consume more
and save less now, knowing that more
income is right around the corner shifting
the saving supply curve to the left.
Copyright © 2002 by Thomson Learning, Inc.
Real Interest Rates, r
Shifts in the Saving Supply Curve
SS2
SS0
r0
C
A
B
SS1
A  B An increase
in saving supply
A  C A decrease
in saving supply
0
Q2
Q0
Q1
Quantity of Saving
(billions of dollars)
Copyright © 2002 by Thomson Learning, Inc.
20.2 Investment and Saving Market

In equilibrium,



desired investment equals desired national
saving at the intersection of the investment
demand curve and the saving supply
curve.
The real equilibrium interest rate is
determined by the intersection of these two
curves.
If the real interest rate is above the
equilibrium real interest rate, forces
within the economy would tend to
restore the equilibrium.
Copyright © 2002 by Thomson Learning, Inc.
20.2 Investment and Saving Market


At a higher than real equilibrium interest
rate, the quantity of savings supplied
would be greater that quantity of
investment demanded; there would be a
surplus of savings at this real interest
rate.
As savers (lenders) compete against
each other to attract investment
demanders (borrowers), the real interest
rate falls.
Copyright © 2002 by Thomson Learning, Inc.
20.2 Investment and Saving Market


Alternatively if the real interest rate is
below the equilibrium real interest rate,
the quantity of investment demanded is
greater than the quantity of saving
supplied at that interest rate and a
shortage of saving occurs.
As investment demanders (borrowers)
compete against each other for the
available saving, the real interest rate is
bid up.
Copyright © 2002 by Thomson Learning, Inc.
Real Interest Rate
Equilibrium in the Saving and Investment
Market
Surplus of Saving
(real interest rate falls)
SS
r1
rE
r2
Shortage of Saving
(real interest rate rises)
Quantity of Saving
and Investment
Copyright © 2002 by Thomson Learning, Inc.
ID
20.3 The Aggregate Demand Curve


The Aggregate Demand curve reflects
the total amounts of real goods and
services that all groups together want to
purchase in a given time period.
It indicates the quantities of real GDP
(RGDP) demanded at different price
levels.
Copyright © 2002 by Thomson Learning, Inc.
20.3 The Aggregate Demand Curve


AD is different than the demand curve
presented in Chapter 4, which looked at
the relationship between the relative
price of a good and the quantity
demanded.
The AD curve slopes downward, which
means that there is an inverse(or
opposite) relationship between the price
level and real gross domestic product
(RGDP) demanded.
Copyright © 2002 by Thomson Learning, Inc.
20.3 The Aggregate Demand Curve


An increase in the price level causes
RGDP demanded to fall.
Conversely, if there is a reduction in the
price level, the quantity of RGDP
demanded rises.
Copyright © 2002 by Thomson Learning, Inc.
Price Level
Aggregate Demand Curve
PL1
PL0
B
A
AD
0
RGDP1 RGDP0
RGDP
Copyright © 2002 by Thomson Learning, Inc.
20.3 The Aggregate Demand Curve

Three complementary explanations
exist for the negative slope of the
aggregate demand curve:



the real wealth effect,
the interest rate effect and
the open economy effect.
Copyright © 2002 by Thomson Learning, Inc.
20.3 The Aggregate Demand Curve

The real wealth effect



The real (adjusted for inflation) value of
any asset of fixed dollar value, like cash,
falls as the price level increases.
People’s real wealth is reduced, reducing
their planned purchases of goods and
services, and lowering the quantity of
RGDP demanded.
If the price level falls, people’s real wealth
in such forms will increase, increasing the
quantity of RGDP demanded.
Copyright © 2002 by Thomson Learning, Inc.
20.3 The Aggregate Demand Curve

The real wealth effect can be
summarized as:


A higher price level  reduced real wealth
 reduced purchasing power  reduced
RGDP demanded
A lower price level  increased real wealth
 greater purchasing power  increased
RGDP demanded.
Copyright © 2002 by Thomson Learning, Inc.
20.3 The Aggregate Demand Curve

The effect of the price level on interest
rates can also cause the AD curve to
have a negative slope.

At a higher price level, consumers will wish
to hold more dollars in order to purchase
those items that they want to buy. That will
increase the demand for money.
Copyright © 2002 by Thomson Learning, Inc.
20.3 The Aggregate Demand Curve


If the demand for money increases, and
the Federal Reserve System, the
controller of the money supply, does not
alter the money supply, then interest
rates will rise.
In other words, the demanders of
dollars will bid up the price of those
dollars—the interest rate.
Copyright © 2002 by Thomson Learning, Inc.
20.3 The Aggregate Demand Curve

At higher interest rates, the opportunity
cost of borrowing rises, and fewer
interest-sensitive investments will be
profitable, reducing the quantity of
investment goods demanded by firms,
as well as the quantity of consumer
durable goods demanded by
households.
Copyright © 2002 by Thomson Learning, Inc.
20.3 The Aggregate Demand Curve


This interest rate effect will cause fewer
investment goods to be demanded and,
consequently, a lower RGDP
demanded.
On the other hand, if the price level fell,
and people demanded less money as a
result, then the interest rates would fall.
Copyright © 2002 by Thomson Learning, Inc.
20.3 The Aggregate Demand Curve

Lower interest rates would trigger
greater investment and consumer
durable spending and a larger real GDP
would result.
Copyright © 2002 by Thomson Learning, Inc.
20.3 The Aggregate Demand Curve

The interest rate effect process can be
summarized as:


A higher price level  increases money
demand (money supply unchanged) 
increases the interest rate  reduces
investments  reduces RGDP demanded;
A lower price level  decreases money
demand (money supply unchanged) 
decreases the interest rate  increases
investments  increases RGDP
demanded.
Copyright © 2002 by Thomson Learning, Inc.
20.3 The Aggregate Demand Curve


Many goods and services are bought
and sold in global markets.
If the prices of goods and services in
the domestic market rise relative to
those in global markets due to a higher
domestic price level, consumers and
businesses will buy more from foreign
producers and less from domestic
producers.
Copyright © 2002 by Thomson Learning, Inc.
20.3 The Aggregate Demand Curve


Because real GDP is a measure of
domestic output, the reduction in the
willingness of consumers to buy from
domestic producers leads to a lower
level of real GDP demanded at the
higher domestic price level.
And if domestic prices of goods and
services fall relative to foreign prices,
more domestic products will be bought,
increasing RGDP demanded.
Copyright © 2002 by Thomson Learning, Inc.
20.3 The Aggregate Demand Curve

The open economy effect can be
summarized as:


An increased price level  decreases the
demand for domestic goods  decreases
RGDP demanded;
A decreased price level  increases the
demand for domestic goods  increases
RGDP demanded.
Copyright © 2002 by Thomson Learning, Inc.
20.4 Shifts in the Aggregate Demand
Curve


As in the supply and demand curves of
Chapter 4, there can be both shifts in
and movements along the AD curve.
The real wealth effect, the interest rate
effect, and the open (or foreign)
economy effect result in the downward
slope of the AD curve (not a shift in AD).

Each of these factors generates a
movement along the AD curve because the
general price level changed.
Copyright © 2002 by Thomson Learning, Inc.
20.4 Shifts in the Aggregate Demand
Curve

The whole AD curve can shift to the
right or left.


If some non-price level determinant causes
total spending to increase, then the AD
curve will shift to the right.
If a non-price level determinant causes the
level of total spending to decline, then the
AD curve will shift to the left.
Copyright © 2002 by Thomson Learning, Inc.
Price Level
Shifts in the Aggregate Demand Curve
Left
Right
Decrease Increase
AD2
0
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RGDP
AD0
AD1
20.4 Shifts in the Aggregate Demand
Curve

Anything that changes the amount of
total spending in the economy (holding
price levels constant) will impact the AD
curve.


An increase in any component of GDP (C,
I, G, and X – M) can cause the AD curve to
shift rightward.
Conversely, decreases in C, I, G, or X – M
will shift AD leftward.
Copyright © 2002 by Thomson Learning, Inc.
20.4 Shifts in the Aggregate Demand
Curve

A whole host of changes could impact
consumption patterns.

shift AD to the right
an increase in consumer confidence,
 an increase in wealth
 a tax cut
 an increase in population


shift AD to the left
consumers expect a recession
 a tax increase

Copyright © 2002 by Thomson Learning, Inc.
20.4 Shifts in the Aggregate Demand
Curve

Since consuming less is saving more,
an increase in savings, ceteris paribus,
would shift AD to the left. Consumer
debt may also be a reason why some
consumers might put off additional
spending.
Copyright © 2002 by Thomson Learning, Inc.
20.4 Shifts in the Aggregate Demand
Curve

Increases in demand for investment
goods, an important determinant of AD,
occur for a variety of reasons.

AD will shift to the right (business
investment increases)
business confidence increases
 real interest rates fall
 business taxes reduced


AD will shift to the left
real interest rates rise
 business taxes rise

Copyright © 2002 by Thomson Learning, Inc.
20.4 Shifts in the Aggregate Demand
Curve


Government purchases is also part of
total spending and therefore must
impact AD.
An increase in government purchases,
other things equal, shifts AD to the right,
while a reduction shifts AD to the left.
Copyright © 2002 by Thomson Learning, Inc.
20.4 Shifts in the Aggregate Demand
Curve



Global markets are also important in a
domestic economy.
If major trading partners are
experiencing economic slowdowns,
then they will demand fewer U.S.
imports.
This causes net exports (X – M) to fall,
shifting AD to the left.
Copyright © 2002 by Thomson Learning, Inc.
20.4 Shifts in the Aggregate Demand
Curve

Alternatively, an economic boom in the
economies of major trading partners
may lead to an increase in our exports
to them, causing net exports (X – M) to
rise and AD to increase.
Copyright © 2002 by Thomson Learning, Inc.