Section 3.3
AGGREGATE DEMAND – the total amount demanded of economic goods and
services produced in a given economy at a given price. AD = C + I + G + X-M
 C = Consumer spending on goods and services, including durable and nondurable goods. Durable goods’ service lasts over time, it is not used up all at
once (refrigerator, washer/dryer, etc.). Non-durable goods are used up very
quickly or when they are used once (food, fuel, paper products, etc.) This is only
as a function of disposable income – income minus taxes.
 I = Investment spending by companies on capital goods. This includes spending
on working capital, like stocks of finished goods and work in progress. (Aka:
Gross domestic fixed capital formation)
 G = Government Spending on goods and services that are publicly provided.
This includes public goods and merit goods. Transfer payments, such as social
security benefits (pensions, job-seekers allowance, etc.) are not included because
they are not payments to a factor of production for the output produced. (Aka:
General government final consumption).
 X = Exports of goods and services sold overseas. These are an inflow of
demand in the circular flow of income of the economy and they add to the
demand of domestically produced output.
 M = Imports of goods and services. These are withdrawals form the circular
flow of income and spending in the economy. Goods and services enter the
economy but money leaves the economy. Because of this, imports are subtracted
from the aggregate demand equation.
*note – net exports (NX) = exports – imports
The slope of the Aggregate Demand curve is downward sloping because as the price level
drops, the quantity of out put demanded increases.
- Keynes’s interest-rate effect is one of the reasons the aggregate demand curve
is downward sloping. The quantity of money demanded depends on price level.
Therefore, at a high price a relatively large amount of currency is needed to make
purchases. Therefore, consumers demand large quantities of currency when the price
level is high and when the price level is low, consumers demand a small amount of
currency because it takes a relatively small amount of currency to make purchases. Thus,
consumers keep more money in the bank causing the amount of currency in the bank to
increase and increasing the supply of loans. The increase in the supply of loans causes
the interest rate (the cost of loans) to decrease. A low interest rate increases the demand
for investment as the cost of investment falls with the interest rate. Therefore, a decrease
in the price level decreases interest rates which increases demand for investment and
thereby increases aggregate demand.
AGGREGATE SUPPLY – measures the amount of output produced in an economy at a
given price.
Short Run AS is determined by the productive capacity of the economy and the
costs of production (the supply side of the economy)
In the short run, economic producers respond directly to changes in price level – as price
increases, output increases and as price decreases – output decreases.
Long Run AS is determined by the productivity resources available to meet the
amount demanded and the productivity inputs – land labor and capital
Long run aggregate supply is determined by factors other than price and demand such as
improvements in productivity and by an expansion of available inputs making supply
independent of the level of price.
Full Employment Level of National Income
National Income is determined by the sustainability of full employment and a sustained
flow of services. Full employment, actual employment and the employment level are
necessary to maintain sustainable income for the economy. There exists a widening gap
between actual income and environmentally sustainable income.
Equilibrium Level of National Income
Where AS meets AD at full employment
Inflationary Gap
The gap between actual output and full employment output; the excess of AD at the full
employment level of real GDP
Deflationary Gap
The gap between full employment output and actual output; the shortfall in AD at the full
employment level of real GDP
The Business Cycle
Mini IA
http://www.reuters.com/article/newsOne/idUSN053061482009030
5
As the U.S continues to experience the recession, further demand for goods fall. Many
factory workers are now unemployed. The article states that we now have the highest
unemployment rate of 16 and half years. The government’s stimulus package to jump
start the economy is associated with the theory of AD. Since government spending is a
component of AD, AD should shift out. The stimulus plan also encourages investment
another component of AD, also trying to shift AD out. There is also a fall in AS there is
less human capital and thus less productivity, which in turn affects AD as no one has
money to purchase goods.