National Income and
Price Determination:
Aggregate Demand
AP Economics
Mr. Bordelon
S
Aggregate Demand
S Aggregate demand (AD) is a curve that shows the
relationship between aggregate price level (APL) and the
quantity of aggregate output demanded by households,
firms, the government, and the rest of the world.
Why does AD have a
downward slope?
S To a certain extent this is due to the law of demand, but this
would be misleading by itself.
S The demand curve for any individual good shows how QD
depends on the price of that good, holding prices of all other
g/s and everything else constant.
S AD focuses on the APL increasing for ALL g/s in the
economy.
S Fine. So what causes it then?
AD Slope
1. Wealth effect
S When price level drops, purchasing power of existing financial
assets (savings, for example) increases. This can increase
consumer spending and there is a downward movement along
the AD curve.
S When price level increases, purchasing power of existing
financial assets decreases. This can decrease consumer
spending and there is an upward movement along the AD
curve.
S Think income effect!
AD Slope
2.
Interest rate effect.
S Decrease in APL means lower interest rates. This can increase
spending.
S
Lower price level increases purchasing power of money you have on
hand. Ultimately, you don’t need as much money to buy g/s. The
decrease in demand for money on hand pushes interest rates down.
S
Nominal interest rate = real interest rate + expected inflation.
S
If inflation falls, so should the nominal interest rate.
S
Lower interest rates increase investment spending, and there’s a
movement along AD as real GDP increases.
AD Slope
2. Interest rate effect.
S Increase in APL means higher interest rates. This can decrease
spending.
Higher price level decreases purchasing power of money you have
on hand. You need more money to buy g/s. Increase in demand
for money pushes interest rates up.
S Nominal interest rate = real interest rate + expected inflation.
S If inflation increases, so should the nominal interest rate.
S Higher interest rates decrease investment spending, and there’s a
movement along AD as real GDP decreases.
S
Example of the curve. Note the different notations on the axes and the curve. If
you do not have the curve or axes labeled correctly, it’s wrong.
Shifts in AD
There is no real difference in the mechanics of the graph when we talk about
shifts of AD vs. D. There difference comes in how we view the changes from
the macroeconomic point of view.
Shifts in AD
S Just to clarify the rules on shifting the curve:
S An increase in AD means a shift of AD to the right.
Rightward shift occurs when aggregate QD increases at any
given APL.
S A decrease in AD means a shift of AD to the left. Leftward
shift occurs when aggregate QD decreases at any given APL.
S
One other point: regardless of shift, the multiplier effect
increases/decreases total spending throughout the economy.
Shifts in AD
S Changes in expectations
S When consumers and businesses see a healthy economy in the
future, they will increase consumption and investment
spending. AD shifts right.
S When consumers and businesses see an economy going down
in the future, they will decrease consumption and investment
spending. Saving for a rainy day! AD shifts left.
Shifts in AD
S Changes in wealth. NOT THE WEALTH EFFECT
S If the value of assets increases, consumers increase
consumption. We know this from the consumption function.
AD shifts right.
S If the value of assets decreases, consumers decrease
consumption. AD shifts left.
S AP Example. Stock market and real estate market tanking,
cascade effect throughout the economy, shifting AD left.
Shifts in AD
S Size of existing stocks (physical capital/inventories)
S If firms have plenty of stock, investment spending slows down.
If investment spending slows down, then AD shifts left. Not
producing as much!
S If firms have bare cupboards, investment spending will
increase. If investment spending increases, then AD shifts
right. Producing more! Woot.
Government Policies
S Fiscal policy. Use of either government spending and transfers or
tax policy to stabilize the economy.
S Legislative and executive power here.
S If government increases spending, this increases AD, shifting
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right.
If government decreases spending, this decreases AD, shifting left.
If government raises taxes, this decreases AD, shifting left.
If government lowers taxes, this increases AD, shifting right.
If government transfers increase, this increases AD, shifting right.
If government transfers decrease, this decreases AD, shifting left.
Government Policy
S Monetary Policy. Use of change in quantity of money or interest
rate to stabilize the economy.
S Federal Reserve.
S Fed increases money supply, households and firms have more
money to lend. This drives interest rates down at any APL,
leading to higher investment spending and consumer spending.
AD shift right.
S Fed decreases money supply, households and firms have less
money to lend. This drives interest rates down at any APL,
leading to lower investment spending and consumer spending.
AD shifts left.
Summary of AD Shifts
Question 1
S For each of the following, draw a correctly labeled AD graph, and
show how each will affect the AD curve. 8 graphs. Citations from
the text, and briefly explain.
Business owners are less optimistic about the health of the economy.
The government decreases welfare and veteran’s benefits.
The Federal Reserve increases interest rates.
A rising price level decreases the value of money held for purchases.
The government lowers personal income taxes.
Consumers expect the job market to be much stronger in the next few
months.
S The stock market has reached new records high levels of value.
S The stock of physical capital has been falling for nearly a year.
S
S
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Question 2
S A fall in the value of the dollar against other currencies
makes U.S. final goods and services cheaper to foreigners
even though the U.S. aggregate price level stays the same.
As a result, foreigners demand more American aggregate
output. Your friend says that this represents a movement
down the aggregate demand curve because foreigners are
demanding more in response to a lower price. You,
however, insist that this represents a rightward shift of the
aggregate demand curve. Who is right? Explain. Use
citations from the text.
Question 3
S Suppose that all households hold all their wealth in assets
that automatically rise in value when the aggregate price
level rises. What happens to the wealth effect of a change in
the aggregate price level as a result of this allocation of
assets? What happens to the slope of the aggregate demand
curve? Will it still slope downward? Explain. Use citations
from the text where/if appropriate.
Question 4
S How will investment spending change as the following
events occur?
S The interest rate falls as a result of Federal Reserve policy.
S The U.S. Environmental Protection Agency decrees that
corporations must upgrade or replace their machinery in order
to reduce their emissions of sulfur dioxide.
S Baby boomers begin to retire in large numbers and reduce their
savings, resulting in higher interest rates.
S Explain and use citations from the text where appropriate.