Unit 3: Aggregate Demand

Aggregate Demand

• AD is the demand by consumer businesses, government and foreign nation
• AD= C+I+G+Xn

AD

• Changes in price level cause a move along the curve not a shift in the 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 the price level and the level of GDPr is inverse. 

3 Reasons why AD is downward Sloping

1. Wealth effect

• Higher Prices reduce the dollar purchasing power.
• This decreases the quantity of expenditures
• Lower price levels increase purchasing power and increase expenditures 

Example

• If the balance in your bank account was $50,000, but the inflation erodes your purchasing power you will likely reduce your spending.
• So if price levels go up then GDP demanded goes down 

      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 spending and business investment.

Example

• Increase in Price leads to an increase in the interest rate from 5% to 25%. This means you are less likely to take out loans to improve your business. 

      3. Foreign Trade Effect 

• When U.S price level rises, foreign buyers purchase fewer goods and Americans buy more foreign goods. 
• Exports fall and Imports rise which cause Real GDP demanded to fall (Xn Decreases) 

Example

• If prices triple in the U.S, Canada will no longer buy U.S goods causing quantity demanded of products to fall. 

Shifts in AD (Two Parts) 

• A change in C, IG, G, and or Xn 
• A multiplier effect that produces a greater change than the original change in components.
• Increase in AD= AD--->
• Decrease in AD= AD<------

Determinants of AD 

• Consumption
• Gross Private Investment 
• Government Spending 
• Net Exports (Xn)= Exports-Imports 

Change in Consumer Spending 

• Consumer wealth (Boom in the stock Market)
• Consumer Expectations (People fear a recession)
• Household in debetness (More consumer dept) 
• Taxes (Decrease in income Taxes) 

Changes in Investment Spending

• Real Interest Rate (Price of borrowing $) 
• If interest Rate Increases 
• If interest decreases
• Future Business Expectations (High Expectations) 
• Productivity and Technology (New Robots) 
• Business Taxes (Higher corporate taxes) 

Change in Government Spending

• War 
• Nationalized Health Care 
• Decrease in Defense Spending

Change in Net Exports (Xn) 

• Exchange Rates 
• If the U.S $ depreciates relative to the euro. 

National Income Compared to abroad 

• If a major importer has a recession
• If the U.S has a recession 

IF THE U.S GETS A COLD, CANADA GETS PNEUMONIA 

AD=GDP

Government Spending

• More Government Spending: AD----->
• Less Government Spending: AD<------