MODULE 17AGGREGATE DEMAND
BY J.A.SACCO
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
The next three modules (17-19) deal with why business
activity fluctuates. A way to explain changes in
output/unemployment/price level.
Go Back to GDP
C+I+G+(X-M)
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C+I+G+(X-M)
The components of GDP determine the value of total
expenditures. Consumers, Business Capital Investment,
Government, Foreign Markets make these spending decisions.
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However, this much to simple an explanation. Two
issues much be answered.
1.
What determines the total amount that individuals,
firms, governments, and foreigners want to spend?
Aggregate
Demand
and
Aggregate
Supply
2.
What determines whether this spending will result
in a higher output of goods/services (quantity) or
higher prices (inflation)?

Answered by developing?
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

Aggregate Demand- TOTAL of all planned
expenditures for the entire economy.
Aggregate Supply- TOTAL of all planned
production for the entire nation.
Aggregate Demand

Aggregate Demand Curve
A
curve showing planned purchase rates for all goods and
services in the economy at various price levels, all other
things held constant

AD Curve is a shorthand way of illustrating the
components of GDP.
Aggregate Demand
C+I+G+(X-M)
Furthermore, AD Curve gives the total
amount of Real Domestic Income (RDI) that
will be purchased at each price level.
RDI = RGDP
Remember Circular Flow.
Price Level/ GDP Deflator
The Aggregate Demand Curve
C
140
As the price level
rises, the quantity of
real GDP
demanded decreases
B
120
A
100
AD
0
1
2
3
4 5
6 7
8
Real GDP per Year
($ trillions)
9
8
10
Price Level/GDP Deflator
The Aggregate Demand Curve
A
140
As the price level
falls, the quantity of
real GDP
demanded increases
B
120
C
100
AD
0
1
2
3
4 5
6 7
8
Real GDP per Year
($ trillions)
9
9
10
Houston, We May Have a Problem!


Question- Why might the Law of Demand and the
reasons for the downward slope of the microeconomic
demand curve not be applicable with aggregate
demand.
Law of Demand (one good/service) states
Pr QD
Pr
QD
Houston, We May Have a Problem!


Now dealing with the entire macroeconomy. Price
level is the average price of all goods and services
including wages. Remember, when the price level for
goods/service increased the consumer would
substitute other goods/services. Now there are no
substititues!
The Law of Demand still applies and the aggregate
demand curve is still downward sloping but for
different reasons.
Downward Slope of the Aggregate Demand Curve?

What Happens When the Price Level Changes?
 The
Direct Effect: The Real-Balance Effect (wealth
effect)
 The Indirect Effect: The Interest Rate Effect
 The Open Economy Effect: The Substitution of Foreign
Goods
The Aggregate Demand Curve

The Real-Balance Effect
 The
change in the real value (purchasing power) of
money balances when the price level changes.
 While your nominal cash value stays the same, any
change in the price level will cause a change in the real
value (purchasing power) of cash balances.
The Aggregate Demand Curve

The Interest Rate Effect- Change in the price level
indirectly effects the interest rate.
Lets look at a Price Level increase.
1.
2.
3.
When price level increases, you go out to replace
your lost purchasing power.
This greater demand for money causes the nominal
interest rate to increase.
As interest rates rise this makes borrowing less
attractive thus reducing the quantity of AD.
A decrease in the price level works in the opposite direction.
The Aggregate Demand Curve

The Open Economy Effect
 Higher
price levels result in foreigners’ desiring to buy
fewer American-made goods while Americans desire
more foreign-made goods (i.e. net exports fall)
 This decline in net exports causes a decrease in the
quantity of aggregate demand.
Review- A Change in the Price Level

Direct Effect/Real Balance Effect/Wealth Effect
If PL
Purchasing Power
Rate of Consumption
Quantity AD
If PL
Purchasing Power
Rate of Consumption
Quantity AD
Review- A Change in the Price Level

Indirect Effect/ Interest Rate Effect
If PL
Demand for Money
Nominal Interest Rate
Consumption/ Investment
Quantity AD
If PL
Demand for Money
Nominal Interest Rate
Consumption/ Investment
Quantity AD
Review- A Change in the Price Level

Open-Economy Effect
If PL
U.S. goods/services more expensive
than foreign. Substitute foreign goods
for U.S. goods/services.
Quantity AD
If PL
U.S. goods/services cheaper than
foreign. More U.S. goods/services
purchased than foreign. Quantity AD
Review- A Change in the Price Level

Remember with any of these three reasons, it is a
change in the Price Level. You are only moving
up/down the AD curve.
Non- Price Determinants of Aggregate Demand

Any non-price-level change that effects any component
of:
C + I + G + (X-M)
will cause a shift in the AD curve.
Non- Price Level Determinants of Aggregate
Demand

1.
2.
3.
4.
5.
6.
Any non-price-level change that increases aggregate
spending (on domestic goods) shifts AD to the right.
A drop in the foreign exchange value of the dollar (weak
dollar)
Increased security about jobs and future income
Improvements in economic conditions in other countries
A reduction in real interest rates (nominal interest rates
corrected for inflation) not due to price level changes
Tax decreases/Increase government spending (fiscal
policy)
An increase in the amount of money in circulation
(monetary policy)
Shifts in the Aggregate Demand Curve
GDP Deflator
Increase in
Aggregate
Demand
120
90
0
1
2
3
4
5
Real GDP per Year
($ trillions)
AD
AD1
6
7
Non-Price Level Determinants of
Aggregate Demand

1.
2.
3.
4.
5.
6.
Any non-price-level change that decreases aggregate
spending (on domestic goods) shifts AD to the left.
A rise in the foreign exchange value of the dollar
(strong dollar)
Decreased security about jobs and future income
Declines in economic conditions in other countries
A rise in real interest rates (nominal interest rates
corrected for inflation) not due to price level changes
Tax increases/Decrease government spending (fiscal
policy)
A decrease in the amount of money in circulation
(monetary policy)
Shifts in the
Aggregate Demand Curve
GDP Deflator
Decrease in
Aggregate
Demand
120
90
AD1
0
1
2
3
4
5
Real GDP per Year
($ trillions)
AD
6
7