Unit III National Income and
Price Determination
AD/AS model
• AD/AS curves look and operate much like S
and D curves in micro
• Depict different concepts
• Change for different reasons
• Used to illustrate changes in real output and
price levels of an economy
Aggregate Demand
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AD represents the sum of consumption, C
Investment, I
Government Expenditures, G
And net exports, Xn
The quantity of real GDP demanded is the
total of all final goods and services that
households, businesses, governments, and
foreigners plan to buy
AD
• Be sure to always label
correctly.
PL
AD
RGDP
Visual 3.1
– Price level
– RGDP
– The relationship is
negative
– As PL rises, the level of
output demanded
decreases.
AD
• How is this similar to a Market Demand curve?
• Why does a Market Demand curve have a
negative slope?
• The AD curves slopes downward for different
reasons.
AD
The downward slope of the AD
curve is explained by 3
macroeconomic effects:
1.Interest rate effect
2.The wealth effect
3.Net export effect
The Interest Rate effect
• Interest rate is the price of borrowing to
purchase capital or durable goods ( houses,
cars)
• As the price level (including interest rates)
increases, businesses buy less capital ,
consumers buy fewer durable goods
• As PL (interest rates) decreases, purchases of
capital and durable goods increase-----giving
AD negative slope
• What is an example of interest sensitive
spending?
The Wealth Effect
• Also called: the real balance effect
• As PL increases, it takes more dollars to
purchase goods: increase in PL decreases
purchasing power of cash balances.
• Faced with decreasing purchasing power (real
wealth) people decrease consumption.
• Decrease in PL causes an increase in
purchasing power so people increase
consumption----------giving the AD curve neg.
slope.
Net Export Effect
• As domestic price level increases ( relative to foreign
price level), domestic products are more expensive
for foreign buyers
• Foreign goods are less expensive for domestic
consumers to buy
• Increase in price level decreases exports and
increases imports which decreases net exports (X-M)
• Decrease in price level will increase X (domestic
goods become relatively less expensive) and
decrease M (as foreign goods become relatively
more expensive) so that Xn increases-giving AD neg.
slope.
Shifts in AD
• Shifts to the right : increases in real GDP
• Shifts to the left: decreases in real GDP
• AD=C + I + G + Xn
• What sort of things will affect the AD curve?
Visual 3.2
Shifts in AD
• Determinants of AD, “shifters”
–Consumer spending
–Investment spending
–Government spending
–Net export spending
–Money supply
How will each of the following affect
the AD curve?
– Changes in government spending
– Changes in income taxes
– Changes in consumer expectations of future
income
– Changes in foreign income
– Changes in business’ expectations of future sales
Which of the 4 sectors of AD will be affected by each
change?
Importance of Investment in
determining AD
• Investment: spending on things that are used
to produce other things (plant, equipment,
machinery, buildings) that a firm uses to
produce output.
• Investment is not the purchase of
stocks and bonds or any other
financial instrument
Determinants of Investment
• Output
• Interest rate
–Demand for a business’ products
determines investment; real GDP is
a measure of the level of demand
in the economy
Determinants of Investment
• The benefit of investing depends on the
demand for the business’ product
• The cost of investing depends on the interest
rate.
– The firm needs to either borrow money to invest
(and pay the interest rate on the loan)
– OR it can invest its own money in which case the
interest rate is the opportunity cost of the
investment because the business has forgone
earning interest.
“To Invest, or not to invest?” That is
the question!
• To decide whether to invest: businesses
compare the interest rate to the expected
profit rate of investment.
• If expected profit is > interest rate, firms will
invest
• As interest rate decreases, there are more
investment opportunities for which expected
profit is > interest rate, firms will invest more.
Challenge
• Draw an investment demand curve showing
investment as an inverse function of the
interest rate.
• Put Interest rate on the y axis and investment
on the x axis.
Visual 3-3