APMacro: Aggregate Demand

5 AD graph2
Aggregate demand is a schedule or curve that shows the amounts of real output, or real GDP, that buyers collectively desire to purchase at each possible price level. The relationship between the price level, as measured by the GDP price index, and the amount of real GDP demanded is inverse. When the price level rises, the quantity of real GDP demanded decreases and when the price level falls, the quantity of real GDP demanded increases. The aggregate demand (AD) curve slopes downward from left to right. There are three reasons why the AD curve slopes downward: wealth effect, interest rate effect, and exchange rate effect.

As the price level increases, the purchasing power of money declines. Similarly, purchasing power increases when the price level decreases. There is an inverse relation between real wealth and the price level. Assume that you are holding some of your wealth in the form of cash under your mattress or in a bank. If prices double, the value of your cash decreases by one half. You are worse off and would reduce your spending, a negative wealth effect. However, if all prices are cut in half your cash is now worth twice as much. Because lower price levels increase the value of wealth in the form of cash holdings, you spend more when price levels fall because of the positive wealth effect. This contribute to an inverse relationship between the price level and real GDP.

When price level rises, interest rates rise too, reducing borrowing and spending. Demand falls as a result, and again we have a negative relationship between price level and real GDP. The opposite is true when prices fall. Decreasing prices mean decreasing interest rates, and lower interest rates stimulate the economy. Consumers will buy more interest sensitive goods such as, cars, furniture, and appliances, that require financing. Businesses will increase spending on property, factories, and equipment when interest rates are low. the interest rate effect thus contributes to the downward slope of AD. The sequence of events is as follows: the price level falls, saving increases, interest rates fall, and real GDP increases. The overall result is an inverse relation between price and quantity, real GDP.

If domestic prices fall, US interest rates will fall. Interest rates are often higher in other countries and this fact will prompt some US investors to invest abroad. For instance, am investor who has US government bonds might sell them to buy German bonds. The result is that this investor will increase their supply of dollars as they try to convert dollars into euros.Therefore, the value of the dollar falls or depreciates relative to the euro. Foreign goods become ore expensive compared to domestic goods and people would rather buy US goods because they are now cheaper,causing US exports to increase and imports to fall. These shifts are not simply or even usually the result of individual actions. Imagine a firm such as the Union Bank of Switzerland (UBS), which manages assets in the United States and other countries. The UBS might choose to shift assets from lower yielding bonds in one country to higher yielding bonds in another. Hundreds of other investment management firms would do the same thing with their individual investors’ assets and this market action would create changes in imports and the value of the dollar. The overall effect on the GDP is as follows: Americans will buy more domestic products and fewer foreign products causing the value of imports to fall. Foreigners will buy more US products causing the value of exports to rise and buy fewer of their own products.Remember that the net exports figure X, which is exports minus imports, is one of the four components of aggregate expenditures all other things being equal, real GDP will expand as net exports increase.

6 AD Shifters
The AD curve will shift when the components of spending change. The components of spending are consumption spending (C), business investments (I), government spending (G) and net exports (X). AD = C + I + G + X

Government spending and taxes are in the hands of the president and Congress; changes, adjustments, and strategies are called fiscal policy.

When government spending (G) goes up, AD does too and the AD curve shifts to the right, When government spending goes down, AD follows, and the AD curve shifts to the left.

When taxes go down, disposable income goes up. People have more money to spend or to save. They will increase their consumption (C) by some percentage of the new disposable income. The result is an increase in AD and the AD curve shifts right.When T increases, disposable income falls; people have less money to spend or save, and C falls. AD goes down and the AD curve shifts left.

When the money supply increases, there is more money to spend, interest rates fall, and consumers can borrow more. The result is that firms and consumers increase their spending and both C and I go up. There is an increase in AD and the AD curve shifts to the right. The reverse happens if money supply decreases or interest rates rise. The money supply is under the control of the Federal Reserve; changes, adjustments, and strategies are called monetary policy.

1) Chapter 6 p.122 #3, 8a, 9a, 11, 12,13
2) Chapter 7 p.14 #2, 6, 8, 11, 14
3) Economic Indicators Quiz – Tuesday 3/1



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