Unit 3 - Aggregate Demand

• Aggregate (total) demand curve

• AD is the demand by consumer, businesses, government, and foreign countries
• Changes in the price level cause move along the curve, not shift of curve
• Shows the amount of Real GDP that the private, public, and foreign sector collectively desire to purchase at each possible price level
• The relationship between price level and level of Real GDP is inverse
• 3 reasons why AD is downward sloping
1. Wealth Effect
• higher prices reduce purchasing power of the dollar
• this decreases the quantity of expenditures
• lower price levels increase purchasing power and increase expenditures
• ex: if the balance in your bank has $50,000, but inflation erodes your purchasing power, you will likely reduce your spending
2. Interest-Rate Effect
• as price level increases, lenders need to charge higher interest rates to get a REAL return on their loans
• higher interest rates discourage consumer's spending and business investment
• ex: increase in prices lead to an increase in the interest rate from 5% to 25% -- you are less likely to take out loans to improve your business
• result... price level goes up, GDP demand goes down (and vice versa)
3. Foreign Trade Effect
• when US price level rises, foreign buyers purchase fewer US goods and Americans buy more foreign goods
• exports fall and imports rise causing real GDP demand to fall (Xn decreases)
• ex: if prices triple in the US, Canda will no longer buy US goods causing quantity demanded of US products to fall
• Shifts in AD
• there are two parts to a shift in AD:
• a change in C, Ig, G, and/or Xn
• a multiplier effect that produces a greater change than the original change in the 4 components
• increases in AD = AD →
• decreases in AD = AD ←
• Increase/decrease in AD

• Determinants of AD
1. Δ in consumer spending (C)
• consumer wealth (boom in the stock market)
• consumer expectations (people fear a recession)
• household indebtedness (more consumer debt)
• taxes (decrease in income taxes)
2. Δ in investment spending (Ig)
• real interest rates (price of borrowing money) (if interest rates increase) (if interest rates decrease)
• future business expectations (high expectations)
• productivity and technology (new robots)
• business taxes (higher corporate taxes means)
3. Δ in government spending (G)
• war
• nationalized health care
• decrease in defense spending
4. Δ in net exports (Xn)
• exchange rates (if  the US dollar depreciates relative to the Euro)
• if the US has a recession
• "if US gets a cold, Canada get pneumonia"
• more government spending (AD →)
• less government spending (AD ←)