29
Aggregate Demand
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McGraw-Hill/Irwin
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EQUILIBRIUM EXPENDITURE
Aggregate Planned Expenditure and
GDP
We’ve already established that households
consume more when their income increases
and that spending is a primary factor in
determining the level of real GDP.
If we establish that Disposable income equals
aggregate income—real GDP—minus net taxes
DI = rGDP – taxes = Aggregate Income
Then we see that Disposable income and
consumption increase when real GDP
increases.
We use this link between consumption and
real GDP to determine equilibrium expenditure.
Assumptions and Simplifications
• To understand the aggregate expenditure model – we
have to use the following assumptions:
– Prices are fixed
– GDP = DI
• Begin with private, closed economy (we don’t trade
with other nations)
• Equilibrium is achieved when C + Ig intersects the 45
deg. Line.
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28-4
Aggregate expenditures, C + Ig (billions of dollars)
Equilibrium GDP
530
C + Ig
(C + Ig = GDP)
510
490
470
450
Equilibrium
point
Aggregate
expenditures
C
Ig = $20 billion
430
410
390
C = $450 billion
370
45°
370 390 410 430 450 470 490 510 530 550
Real domestic product, GDP (billions of dollars)
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28-5
EQUILIBRIUM EXPENDITURE
Figure 29.5 shows equilibrium
expenditure or the break even
level of income.
1. When aggregate planned
expenditure exceeds real GDP,
an unplanned decrease in
inventories occurs. Results in
increase in production and rise of
GDP.
2. When aggregate planned
expenditure is less than real
GDP, an unplanned increase in
inventories occurs. Results in
cutback in production and decrease
in GDP.
EQUILIBRIUM EXPENDITURE
3. When aggregate planned
expenditure equals real GDP,
there are no unplanned
inventories and real GDP
remains at equilibrium
expenditure.
Part (b) shows the unplanned
changes in inventories that
bring about equilibrium
expenditure. We always
gravitate to equilibrium over
time.
ADDING the Components of GDP
Aggregate Expenditures (billions of dollars)
Adding C then I then G then Xn leads to the Aggregate Expenditures model
C + Ig + Xn + G
Government
Spending of
$20 Billion
o
45
C + Ig + Xn
C
o
470
550
Real domestic product, GDP (billions of dollars)
THE EXPENDITURE MULTIPLIER
When any component of GDP (C,I,G,Xn) increases, the real
GDP increases
But the increase in real GDP is larger than the increase of the
individual the component of GDP.
We call this the multiplier effect or the amount by which a
change in any component of GDP is magnified or multiplied
to determine the overall change that it generates in
equilibrium expenditure and real GDP. (1/MPS)
The Multiplier, Imports, and Income Taxes
THE MULTIPLIER EFFECT –
Aggregate Expenditures
1. A $0.5 trillion increase in
investment shifts the AE curve
upward by $0.5 trillion from
AE0 to AE1.
2. Equilibrium expenditure
increases by $2 trillion from
$13 trillion to $15 trillion.
3. The increase in equilibrium
expenditure is 4 times the
increase in investment, so the
multiplier is 4.
The AD CURVE AND EQUILIBRIUM …
Deriving the AD Curve from Equilibrium Expenditure
• The AE curve is the relationship between aggregate
planned expenditure and real GDP when all other
influences on expenditure plans remain the same.
• A movement along the AE curve arises from a change in
real GDP.
THE AD CURVE AND
EQUILIBRIUM …
The AD curve is the relationship between the
quantity of real GDP demanded and the price
level when all other influences on expenditure
plans remain the same.
– A movement along the AD curve arises from a
change in the price level.
– The Aggregate Expenditures line will shift up or
down depending on the price level. If prices go
down AE will shift up. If prices rise, AE will
shift down.
THE AD CURVE AND
EQUILIBRIUM …
Figure 29.8 shows the connection
between the AE curve and the AD
curve.
1. When the price level is 110, the AE
curve is AE0.
Equilibrium expenditure is $14
trillion at point B.
The quantity of real GDP
demanded at the price level of
110 is $14 trillion—one point
on the AD curve.
29.4 THE AD CURVE AND
EQUILIBRIUM …
2. When the price level rises to 130, the
AE curve shifts downward
to AE1.
Equilibrium expenditure
decreases to $13 trillion at point A.
The quantity of real GDP
demanded at the price level of
130 is $13 trillion—a
movement along the AD curve
to point A.
29.4 THE AD CURVE AND
EQUILIBRIUM …
3. When the price level falls to 90,
the AE curve shifts upward
to AE2.
Equilibrium expenditure
increases to $15 trillion at
point C.
The quantity of real GDP
demanded at the price level
of 90 is $15 trillion—a
movement along the AD
curve to point C.
Aggregate Demand
• Aggregate Demand is the total demand for
everything a nation creates.
• AD is equal to the summation of all of the
components of GDP – that’s because goods and
services can only be purchased (demanded) by
one of four entities:
C + I + G + Xn = GDP = AD
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29-17
Aggregate Demand
• Shows the inverse relationship between real
GDP and the amount that buyers
collectively desire at each price level (these
buyers include the entire nation’s households, businesses and the
government along with consumers aboard)
•Inverse relationship between price
level and GDP (P inc, GDP dec. and vice versa)
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29-18
AGGREGATE DEMAND CURVE
The figure shows the aggregate demand schedule and
aggregate demand curve.
Each point A to E
on the AD curve
corresponds to a
row of the
schedule.
Aggregate Demand
• AD curve is downward sloping to show the inverse
relationship – when AD curve moves downward, it moves
to a lower price level…there are three reasons that the
curve is downward sloping –changes in these three things
cause movement along the AD curve itself.
• Real balances effect (higher prices reduce purchasing power of the
•
•
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households)
Interest effect (when price levels rise, households need more money –
because the money supply is fixed in aggregate, increased demand for
money will drive up the price paid for it’s use – which is the interest rate.
Higher interest rates drive down investments and decrease consumption)
Foreign purchases effect (when US prices rise relative to foreign prices,
foreigners buy less American goods, and Americans buy more foreign
goods)
29-20
3 Reasons the Price Level Influences the Qd of Real GDP
1. The Buying Power of Money
(Real Balances or Wealth Effect)
• A rise in the price level lowers
the buying power of money and
decreases the quantity of real
GDP demanded.
• For example, if the price level
rises and other things remain
the same, a given quantity of
money will buy less goods and
services, so people cut their
spending.
• As a result, the quantity of real
GDP demanded decreases.
3 Reason the Price Level Influences the Qd of Real GDP
2. The Real Interest Rate Effect
• When the price level rises, the
real interest rate rises.
• An increase in the price level
increases the amount of money
that people want to hold—
increases the demand for
money. Interest rates rise.
• Faced with a higher real interest
rate, businesses and people
delay plans to buy new capital
goods and consumer durable
goods and cut back on spending.
• As a result, the quantity of real
GDP demanded decreases.
3 Reasons the Price Level Influences the Qd of Real GDP
3. The Real Prices of Exports and Imports(Net Export Effect or
Foreign Purchases Effect)
• When the U.S. price level rises and other things remain the same,
the prices in other countries do not change.
• So a rise in the U.S. price level makes U.S.-made goods and
services more expensive relative to foreign-made goods and
services.
• This change in real prices encourages people to spend less on U.S.made items and more on foreign-made items and GDP declines.
What Causes the AD Curve to Shift ?
• An AD curve shifts just like
a regular demand curve.
Any change in your
formula variables
(C+I+G+Xn) can shift it or
any of the following 3
factors:
• Expectations about the
future
• Fiscal policy and
monetary policy
• The state of the world
economy
Price level
Changes in Aggregate Demand
AD2
AD3
AD1
0
Real domestic output, GDP
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29-25
Determinants of AD – Changes to a GDP
Variable (C + I + G + Xn)
• Changes in price level may change C and lead to a
shift in AD Curve
• Consumer wealth (wealth effect – shifts the AD curve the right)
• Household borrowing (Borrowing shifts the AD curve to the right
because of an immediate increase in disposable income)
• Consumer expectations (When consumers expect prices to rise, they
will spend more now – shifts AD curve to the right)
• Personal taxes (reduction in income tax raises take home income and
shifts AD curve to the right)
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29-26
Determinants of AD – Changes to a GDP
Variable (C + I + G + Xn)
• Investment is the purchase of capital goods; when interest
•
•
rates and price levels change for capital goods, this can
impact the AD curve.
Real interest rates (ceteris parabus, an increase in I will raise
borrowing costs and will lower investment demand, shifts AD
curve to the left.)
Expected returns (if firms anticipated greater profit, investment
demand will increase and will shift AD curve to the right)
• Factors that influence expected returns
• Expectations about future business conditions
• Technology
• Degree of excess capacity – unused capital will reduce the rate of
return and decrease AD; shifts left
• Business taxes
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29-27
Determinants of AD – Changes to a GDP
Variable (C + I + G + Xn)
• Government spending increases
• Aggregate demand increases (as long as
interest rates and tax rates do not change)
• More transportation projects
• Government spending decreases
• Aggregate demand decreases
• Less military spending
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29-28
Determinants of AD – Changes to a GDP
Variable (C + I + G + Xn)
• When exports increase, there is a higher foreign demand for
•
•
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US goods – rise is net export = right shift of AD
National income abroad – encourage foreigners to buy more
imported goods; increase net exports, increase AD
Exchange rates (price of foreign currencies in terms of US
dollars)
• Dollar depreciation (meaning euro is worth more than the
dollar, Europeans can buy more US stuff with fewer euros –
increase AD)
• Dollar appreciation (opposite affect)
29-29
Determinants of AD – Changes to Fiscal v.
Monetary Policy
Fiscal Policy and Monetary Policy
• Government can use fiscal policy
to influence aggregate demand.
• Fiscal policy is when the
government changes taxes,
transfer payments, and
government expenditures on
goods and services.
• The Federal Reserve can use
monetary policy to influence
aggregate demand.
• Monetary policy is when the
Federal Reserves changes the
quantity of money in circulation
and the interest rate.
AGGREGATE DEMAND
The figure shows changes in
aggregate demand.
1. Aggregate demand
increases if
• Expected future
income, inflation, or
profits increase.
• Fiscal policy or
monetary policy
increase planned
expenditure.
• The exchange rate falls
or foreign income
increases.
AGGREGATE DEMAND
2. Aggregate demand
decreases if
•Expected future
income, inflation, or
profits decrease.
•Fiscal policy or
monetary policy
decrease planned
expenditure.
•The exchange rate rises
or foreign income
decreases.
Aggregate Demand Practice
What Happens to AD?
Situation
Change New Why?
in AD
AD
(right/left)
Curve
1. Congress cuts Right
taxes.
2. Investment
spending
decreased.
3. “G” spending
to increase
without increase
in taxes.
AD2
4. Survey shows consumer
confidence jumps.
5. Stock market collapses;
investors lose billions.
6. Government increases taxes
by $400 billion; increases
spending by $400 billion
7. Defense spending is cut by
20%, no increase in domestic
spending
8. Japan experiences a surge in
wage rates.