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Ch.10- Aggregate Demand/Aggregate Supply

Ch.10- Aggregate Demand/Aggregate Supply. BY J.A.SACCO. Let Us Build Our Model!. Chapter deals with why business activity fluctuates. A way to explain changes in output/unemployment/price level. Go Back to GDP. C+I+G+(X-M). Let Us Build Our Model!. C+I+G +(X-M).

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Ch.10- Aggregate Demand/Aggregate Supply

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  1. Ch.10- Aggregate Demand/Aggregate Supply BY J.A.SACCO

  2. Let Us Build Our Model! • Chapter deals with why business activity fluctuates. A way to explain changes in output/unemployment/price level. Go Back to GDP C+I+G+(X-M)

  3. Let Us Build Our Model! 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.

  4. Let Us Build Our Model! • However, this much to simple an explanation. Two issues much be answered. • What determines the total amount that individuals, firms, governments, and foreigners want to spend? • What determines whether this spending will result in a higher output of goods/services (quantity) or higher prices (inflation)? Aggregate Demand and Aggregate Supply Answered by developing?

  5. Let Us Build Our Model! • Aggregate Demand- TOTAL of all planned expenditures for the entire economy. • Aggregate Supply- TOTAL of all planned production for the entire nation.

  6. 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.

  7. 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.

  8. C As the price level rises, real GDP demanded declines B A AD The Aggregate Demand Curve 140 Price Level/ GDP Deflator 120 100 0 1 2 3 4 5 6 7 8 9 10 Real GDP per Year ($ trillions)

  9. A As the price level falls, real GDP demanded increases B C AD The Aggregate Demand Curve 140 120 Price Level/GDP Deflator 100 0 1 2 3 4 5 6 7 8 9 10 Real GDP per Year ($ trillions)

  10. Houston, We May Have a Problem! • Question- Why might the Law of Demand and the reasons for the downward slope of the demand curve not be applicable with aggregate demand. • Law of Demand (one good/service) states Pr QD Pr QD

  11. 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.

  12. 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

  13. 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.

  14. The Aggregate Demand Curve • The Interest Rate Effect- Change in the price level indirectly effects the interest rate. • 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. Lets look at a Price Level increase. A decrease in the price level works in the opposite direction.

  15. 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.

  16. 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

  17. Review- A Change in the Price Level • Indirect Effect/ Interest Rate Effect If PL Demand for Money Nominal Interest Rate Consumption/ Investment Quantity AD Demand for Money Nominal Interest Rate Consumption/ Investment Quantity AD If PL

  18. 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

  19. 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.

  20. 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.

  21. Non- Price Determinants of Aggregate Demand • 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 • 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 (Fiscal Policy) • An increase in the amount of money in circulation (Monetary Policy)

  22. AD Shifts in the Aggregate Demand Curve Increase in Aggregate Demand 120 GDP Deflator 90 AD1 0 1 2 3 4 5 6 7 Real GDP per Year ($ trillions)

  23. Determinants ofAggregate Demand • 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 • 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 (Fiscal Policy) • An decrease in the amount of money in circulation (Monetary Policy)

  24. AD Shifts in theAggregate Demand Curve Decrease in Aggregate Demand 120 GDP Deflator 90 AD1 0 1 2 3 4 5 6 7 Real GDP per Year ($ trillions)

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