Aggregate Demand
Aggregate Demand
Aggregate Demand slopes downward
like other demand curves, but for
different reasons.
Aggregate Demand
• An increase in the aggregate price level will
cause real spending to decrease. This is seen
as a movement upward along a given AD
curve
• Because GDP = C+I+G+(X-M), anything that
increases one of these components will shift
AD to the right
Aggregate Demand
• The AD curve slopes downward, but it is not
the usual law of Demand that explains this
slope.
• AD is a curve that shows the relationship
between the aggregate price level and the
quantity of aggregate output demanded by
households, firms, the government, and the
rest of the world.
Why is the AD curve downward sloping?
• Wealth or real balances effect
– When price level falls, purchasing power of existing
financial assets (like money in your savings
account) rises, this can increase consumer
spending and there is a downward movement
along the fixed AD curve.
• Interest-rate effect –
– A decline in price level means lower interest rates
which can increase levels of certain types of
spending. How does this work?
Why is the AD curve downward sloping?
• A lower price level increases the purchasing
power of money in your pocket so you need to
hold less money to buy your goods and services.
• This decrease in the demand for money holdings
puts downward pressure in interest rates.
• Remember – Nominal interest rate = real interest
rate + expected inflation. If inflation expectations
gradually fall, nominal interest rates should also
gradually fall.
• Lower interest rates will increase investment
spending, thus increasing real GDP along the AD
curve.
Shifts of the Aggregate Demand Curve
• There are shifts of the aggregate demand curve,
changes in the quantity of goods and services
demanded at any given price level.
• An increase in Aggregate demand means a shift
of the AD curve to the right.
• A rightward shift occurs when the quantity of
aggregate output demanded increases at any
given aggregate price level.
Shifts of the Aggregate Demand Curve
• A decrease in aggregate demand means that
the AD curve shifts to the left.
• A leftward shift implies that the quantity of
aggregate output demanded falls at any given
aggregate price level.
• Whether AD shifts to the right or to the left,
the multiplier effect increases, or decreases,
total spending throughout the economy
Shifts of the Aggregate Demand Curve
• Changes in Expectations: When consumers and
firms are more optimistic about their future
economic prospects, they will increase
consumption and investment spending.
– This shifts the AD to the right
• Changes in Wealth – When the value of
accumulated household assets goes up, consumers
respond by increasing current consumption. This is
one reason why a weak stock market or real estate
market has a negative ripple effect in the economy
– Shifting the AD to the left
Shifts of the Aggregate Demand Curve
• Size of the Existing Stock of Physical Capital:
• Firms plan to invest in physical capital when
the stock is being depleted or is insufficient to
meet demand for their products
– If firms have plenty of physical capital already,
investment spending will slow down.
Shifts of the Aggregate Demand Curve
• Government Policies and Aggregate Demand:
– Government can have a powerful influence on
aggregate demand and that, in some
circumstances, this influence can be used to
improve economic performance
• Two main ways the government can influence
the aggregate demand are through fiscal
policy and monetary policy
Shifts of the Aggregate Demand Curve
• Fiscal Policy – Congress and the President
control fiscal policy.
• Fiscal policy is the use of either government
spending – government purchases of final
goods and services and government transfers
– or tax policy to stabilize the economy.
• Suppose the economy was in a recession. The
government can intervene directly or
indirectly.
Shifts of the Aggregate Demand Curve
• If the government increases spending (G), it
will have a direct impact on AD by shifting AD
to the right.
• If the government decreases taxes, this would
increase disposable income, and this would
increase consumption spending.
• The increase in C would shift the AD curve to
the right, helping to indirectly reverse the
recession.
Shifts of the Aggregate Demand Curve
• Monetary Policy – The Federal Reserve controls
monetary policy – the use of changes in the quantity of
money or the interest rate to stabilize the economy.
• When the Federal Reserve (the Fed) increases the
quantity of money in circulation, households and firms
have more money, which they are willing to lend out.
• This drives the interest rate down at any given
aggregate price level, leading to higher investment
spending and higher consumer spending.
• Thus increasing the quantity of money shifts the
aggregate demand curve to the right.