Aggregate Demand
aggregate-a total (gross) amount
1.
2.
3.
4.
How is aggregate demand different than demand?
What are the components of AD? Why is this important?
How is the AD curve constructed?
Explain what the AD curve shows, including why the
curve is downward sloping.
The Basic Model of Economic
Fluctuations
• Two variables are used to develop a model to
analyze the short-run fluctuations.
– The economy’s output of goods and services
measured by real GDP.
– The overall price level measured by the CPI or the
GDP deflator.
• The Basic Model of Aggregate Demand and
Aggregate Supply
– Economist use the model of aggregate demand and
aggregate supply to explain short-run fluctuations in
economic activity around its long-run trend.
Where does the concept originate?
The AS-AD Model
• Aggregate demand-total quantity of aggregate output
(real GDP), that all buyers in an economy want to buy at
different possible price levels, ceteris paribus
– Simpler terms: “sum of total planned expenditure for a given
price level by households, firms, gov’t, and foreign sectors during
a period of time
• The macroeconomic aggregate demand-aggregate
supply model is fundamentally different from the
microeconomic demand/supply model.
• HOW? WHY?
AS-AD Model: How and Why
• Microeconomic supply/demand curves concern the price
and quantity of a single good:
– Price of a single good is measured on the x-axis and quantity of
a single good is measured on the y-axis
– The shapes are based on the concepts of
substitution/complements and opportunity cost
• In the AS-AD model the price of everything is included
– Aggregate output (real GDP) is on the x-axis, price level on the
y-axis (average of prices of all goods/services, measured by
GDP deflator)
– Substitutions/complements can’t be graphed, since we’re
showing aggregates—to overcome, we use inflation-adjusted
monetary value of real GDP
– Shapes based on GDP
In other words…
• AD curve is unlike any other curve you’ve encountered in
this text
– In all other cases, our curves have represented
simple behavioral relationships
• But AD curve represents more than just a behavioral
relationship between two variables
– Each point on curve represents a short-run
equilibrium in economy
• A better name for AD curve would be “equilibrium output
at each price level” curve—not a very catchy name
– AD curve gets its name because it resembles
demand curve for an individual product
– AD curve is not a demand curve at all, in spite of its
name
Figure 3 The Aggregate-Demand Curve...
Price
Level
P
P2
1. A decrease
in the price
level . . .
0
Aggregate
demand
Y
Y2
Quantity of
Output
2. . . . increases the quantity of
goods and services demanded.
Copyright © 2004 South-Western
Aggregate Demand Curve
• The aggregate demand curve shows the
relationship between the quantity of aggregate
output demanded (real GDP demanded) and the
aggregate price level (economy’s price level),
ceteris paribus
• SO: a fall in the average price level (GDP
deflator) will lead to a movement along the AD
curve (ie., increase in real GDP) at a given price
level
– We assume ceteris paribus for all other variables
(we’ll show change in AD curve next time)
The Aggregate Demand Curve
• The aggregate demand (AD) curve shows how
a change in the price level changes aggregate
expenditures on all goods and services in an
economy.
• It shows the level of expenditures that would
take place at every price level in the economy.
• The AD is a downward sloping curve.
The Slope of the AD Curve
• Aggregate demand is composed of the sum of
aggregate expenditures.
• Same components of AD as those in
expenditure method of GDP accounting:
GDP (Y) = C + I + G +(X - M)
– Consumption (C), investment expenditure (I), gov’t
spending (G), export revenue (X), import expenditure
(-M)
The Aggregate Demand Curve
• Aggregate Demand is the total value of real GDP that
all sectors of the economy (C + I + G + (X-M)) are
willing to purchase at various price levels.
When the
price level
increases,
(inflation),
people
purchase
less output.
AD Curve slopes Downward
(Movement along the curve)
• Real Income (Wealth) Effect
– You feel poorer, so you spend less
– Purchasing power declines with inflation (incr. in price
level)
• Upward movement along AD curve (and vice-versa)
• (Real Balance) Interest Rate Effect
– Rising prices push up interest rates (due to
consumers/firms needing more money to carry out
purchases/transactions)
– Lenders need higher interest rates to compensate for
eroding purchasing power of money
• Leads to fall in quantity of output (upward movement on ADc)
• Foreign Purchases (int’l trade) Effect
– If prices rise in the US (but not abroad), exports
decrease and imports increase, so (X-M) decreases
The Interest Rate Effect
• The interest rate effect works as follows:
a decrease in the price level 
increase of real cash 
banks have more money to lend 
interest rates fall 
investment expenditures increase
Economic shorthand (p. 279)
• Real income effect:
– Δ↓price level→ Δ↑Yreal → Δ↑C → Δ↑QAD
• Y=money
• Real balance effect:
– Δ↓price level→ Δ↑value real savings → Δ↑potential future C & I
→ Δ↓opp. cost present C & I → Δ↑ C & I → Δ↑QAD
• International trade effect:
– Δ↓domestic price level → Δ↑relative PM → Δ↓M → Δ↑QAD
– Δ↓domestic price level → Δ↓relative PX → Δ↑X → Δ↑QAD
• P=trade partner
• M=import expenditures
• Relative=in comparison to/with
Explain what’s happening here…
Aggregate Demand Shift
(Determinants of AD)
How is shifting aggregate demand different than a
graph of aggregate demand?
What are the determinants of aggregate demand?
How will determinants shift the AD curve? Why?
Some differences
• When we move along AD
curve in Figure 2, we
assume that price level
changes
– But that other influences on
equilibrium GDP are
constant
• Keep following rule in
mind:
• When a change in price
level causes equilibrium
GDP to change, we move
along AD curve (E to H)
• Whenever anything other
than price level causes
equilibrium GDP to change,
AD curve itself shifts
Determinants of AD
• Movement along the AD curve is caused by changes in the price
level
– Price level=average of current prices across the entire spectrum of
goods and services produced in the economy
• Shifts left or right of the AD curve are caused by the determinants of
AD
Rightward shift from
AD1 to AD2 means that
AD increases: for any
price level, a larger
amount of real GDP is
demanded.
A leftward shift would
mean that AD decreases:
for any price level, a
smaller amount of real
GDP is demanded.
The determinants
• Since AD is composed of consumer spending (C),
investment spending (I), government spending (G) and
net export spending (X-M), changes in AD can be
caused by any factor that produces a change in one of
these four components
• Four shifters:
1. Changes in consumption spending
2. Changes in investment spending
3. Changes in government spending
4. Changes in net exports (foreign spending)
Consumption spending (p. 238)
• Changes in:
– Consumer confidence
– Interest rates
(monetary policy)
– Wealth
– Personal income taxes
(fiscal policy)
– Level of
“indebtedness”
Investment spending (p.239)
• Changes in:
– Business confidence
– Interest rates (monetary
policy)
– Improvement in technology
– Business taxes (fiscal
policy)
– Level of corporate
indebtedness
– Legal/institutional changes
Government spending (p. 239)
• Changes can be due to shift in political priorities, or shift in economic
priorities (fiscal policy)
– Increased gov’t spending shifts AD to right; decrease shifts AD to left
• Policy makers can use fiscal policy and monetary policy to shift
the aggregate demand curve
• Fiscal policy: setting a budget for government spending for the next
year (i.e., changing tax rates)
 Tax and/or  government spending   AD
• Monetary policy: central bank of a country (i.e, the Federal
Reserve in the US) adjusts interest rates (r) or money supply in
circulation
– EX: increase in interest rate results in rising opp. cost of consumption
(more interest forgone by saving); interest payments increase
Federal Reserve  money supply   interest rates  spending   AD
Foreign spending
• Changes in:
– National income
abroad (trading
partners’ income)
– Exchange rates
– Level of trade
protection
• Ceteris paribus: no
trade barriers exist
(i.e., tariffs)
Shifts of the Aggregate Demand
Curve – Rightward Shift
Shifts of the Aggregate Demand
Curve – Leftward Shift