AGGREGATE DEMAND

Aggregate demand is a measurement of the total amount of demand for all finished goods
and services produced in an economy. Finished products are goods and services that have
been fully manufactured – not including intermediate goods that are used as inputs in the
production process. Aggregate demand is expressed as the total amount of money
exchanged for those goods and services at a specific price level and point in time.

Everything purchased in a country is the same thing as everything produced in a country.

As a result, aggregate demand equals the gross domestic product of that economy.

Aggregate demand is the sum of four components:

1. Consumption,

2. Investment,

3. Government spending, and

4. Net exports.
Aggregate demand is calculated by adding the amount of consumer spending,
government and private investment spending, and the net of imports and exports. It is
represented with the following equation: AD = C + I + G + Nx.
Aggregate demand is the sum of the demand curves for different sectors of the
economy. This is usually divided into four components:
Consumer Spending
Consumer spending represents the demand by individuals and households within the
economy. While there are several factors in determining consumer demand, the most
important are consumer incomes and the level of taxation.
Investment,
Investment can change in response to its expected profitability, which in turn is shaped
by expectations about future economic growth, the creation of new technologies, the
price of key inputs, and tax incentives for investment. Investment can also change when
interest rates rise or fall.

Government Spending
Government spending represents the demand produced by government programs,
such as infrastructure spending and public goods. This does not include services such
as Medicare or social security, because these programs simply transfer demand from
one group to another.
Calculating Aggregate Demand
The equation for aggregate demand adds the amount of consumer spending, private
investment, government spending, and the net of exports and imports. The formula is
shown as follows:
Aggregate Demand=C + I + G + Nx
Where:
C=Consumer spending on goods and services
I=Private investment and corporate spending onnon-final
capital goods (factories, equipment, etc.)
G=Government spending on public goods and socialservices
(Infrastructure, Medicare, etc.)
Nx=Net exports (exports minus imports)

Factors That Influence Aggregate Demand

 Aggregate demand can be impacted by a few key economic factors. Rising or falling
interest rates will affect decisions made by consumers and businesses. Rising
household wealth increases aggregate demand while a decline usually leads to lower
aggregate demand. Consumers' expectations of future inflation will also have a
positive correlation on aggregate demand. Finally, a decrease (or increase) in the
value of the domestic currency will make foreign goods costlier (or cheaper) while
goods manufactured in the domestic country will become cheaper (or costlier)
leading to an increase (or decrease) in aggregate demand.

1. Interest Rates
2. Income and Wealth
3. Inflation Expectations
4. Currency Exchange Rates
1. Interest Rates

Whether interest rates are rising or falling will affect decisions made by consumers
and businesses. Lower interest rates will lower the borrowing costs for big-ticket
items such as appliances, vehicles, and homes. Also, companies will be able to
borrow at lower rates, which tends to lead to capital spending increases. Conversely,
higher interest rates increase the cost of borrowing for consumers and companies. As
a result, spending tends to decline or grow at a slower pace, depending on the extent
of the increase in rates.

2. Income and Wealth

Income and Wealth: As household wealth increases, aggregate demand usually increases
as well. Conversely, a decline in wealth usually leads to lower aggregate demand.
Increases in personal savings will also lead to less demand for goods, which tends to
occur during recessions. When consumers are feeling good about the economy, they tend
to spend more leading to a decline in savings.
3. Inflation Expectations:

Consumers who feel that inflation will increase or prices will rise, tend to make
purchases now, which leads to rising aggregate demand. But if consumers believe prices
will fall in the future, aggregate demand tends to fall as well.

4. Currency Exchange Rates:

If the value of the U.S. dollar falls (or rises),foreign goods will become more (or less
expensive). Meanwhile, goods manufactured in the U.S. will become cheaper (or
more expensive) for foreign markets. Aggregate demand will, therefore, increase (or
decrease).

Aggregate Demand Curve

It is determined by real GDP. Real GDP (Y) has four components:

– Consumption (C)
 – Investment (I)

– Government purchases (G)

– Net exports (NX)

– Y = C + I + G + NX
Most of the variables (C, I, & NX) are determined by the price level; government
purchases
(G) is an exception and normally determined by the decisions of policymakers.

There are several channels that prices can use to affect real GDP and aggregate demand

(AD). They are:

– The Wealth Effect

– The Interest-rate Effect

– The International-trade Effect

The Wealth Effect

The way a change in the price level affects consumption (C)

 While income affects household consumption the most, but wealth does as well.
 Some household wealth is held in nominal assets, so as price levels rise, the real
value of household wealth declines. This results in less consumption. (Example:
Price of oranges goes up; you cannot buy as many oranges as before assuming
your wealth has not changed.)
 Implication: higher price level leads to lower consumption.

The Interest Effect

The way a change in the price level affects investment (I)

 As prices rise, households & firms need more money to finance their buying and
selling.
  Households & firms can borrow & withdraw funds from banks and/or they can
sell financial assets such as bonds. They do this to have more funds available.
 With this though, there is an increase in the demand for money. This causes the
interest rate (the price/cost of holding money) to increase and this discourages
firm investment.
 Implication: higher price level leads to lower investment.

The International-trade Effect

The way a change in the price level affects net exports (NX)

 When domestic price levels increase, domestic exports become more expensive
and imports become relatively cheaper.
 Fewer exports and more imports means net exports falls.
Implication: higher price level leads to lower net exports.
Shift of the Aggregate Demand curve Movements along it

The aggregate demand curve shows the relationship between the price level and
Real GDP demanded, holding everything else constant.

 A movement along the AD curve will occur when the price level changes and
the change in prices is not caused by a component of real GDP changing.

 A shift of the AD curve will occur when some component (C, I, G, & NX) of real
GDP changes; for example, a change in government purchases.

Variable that Shift the aggregate Demand Curve

 Monetary policy: The actions the Federal Reserve takes to manage the money
supply and interest rates to pursue macroeconomic policy objectives.
 Fiscal policy: Changes in federal taxes and purchases that are intended to achieve

macroeconomic policy objectives.

 Households’ or Firms’ attitudes about the economy: Their optimism (or

pessimism) about the future increases (or decreases) consumption and/or
investment.
 Foreign incomes: If theirs rise more slowly than ours, their imports of our goods
fall; if ours rise more slowly, our imports fall. If our exchange rate (the value of
the $US) rises, our exports become more expensive, so foreigners buy less of them
(and we buy more imports, also) and vice versa.

Variables That Shift Aggregate Demand Curve:

Monetary Policy
An increase in shifts the aggregate
demand curve … because …

interest rates higher interest rates raise the

cost to households and firms
of borrowing, reducing
consumption and investment
spending.

A decrease in … because …

interest rates lower interest rates lower the

cost to households and firms
of borrowing, increasing
consumption and
investment spending.

Fiscal Policy - Personal Income Taxes

An increase in shifts the aggregate
demand curve … because …

personal income taxes personal income decreases

and consumption does as well.
A decrease in … because …

personal income taxes personal income increases and

consumption does as well.

Fiscal Policy – Attitudes of Households and Firms

households expect their future incomes to rise consumption spending and the residential
and/or firms expect their future profitability of investment component of investment spending
investment spending to rise increase and/or overall investment spending
increases.

households expect their future incomes to fall consumption spending and the residential
and/or firms expect their future profitability of investment component of investment spending
investment spending to fall decreases and/or overall investment spending
decreases.

Foreign Incomes
the growth rate of domestic GDP relative to the Exports will increase faster than imports,
growth rate of foreign GDP decreases and/or increasing net exports and/or exports will rise
the exchange rate (the value of the dollar) and imports will fall, increasing net exports.
relative to foreign currencies decreases
 the growth rate of domestic GDP relative to the imports will increase faster than exports,
growth rate of foreign GDP increases and/or the reducing net exports and/or imports will rise
exchange rate (the value of the dollar) relative and exports will fall,
to foreign currencies increases Decreasing net exports.

Aggregate Supply
Aggregate supply refers to the quantity of goods and services that firms are willing and
able to supply.

The relationship between this quantity and the price level is different in the long and
short run.

So we will have two curves:

 Long-run aggregate supply (LRAS) curve: A curve that shows the relationship
in the long run between the price level and the quantity of real GDP supplied.

 Short-run aggregate supply (SRAS) curve: A curve that shows the relationship
between the price level and the quantity of goods and services firms are willing to
supply, holding constant all other variables that affect the willingness of firms to
supply goods and services.
Long-run Aggregate Supply Curve

Short-run Aggregate Supply Curve

Long –run Aggregate Supply

Short-run Aggregate Supply

The SRAS is upward-sloping. Why?

 As prices of final goods and services rise, prices of inputs—such as the wages of
workers

or the price of natural resources—rise more slowly.

 A secondary reason is that some firms are slow to adjust their prices when the
price level rises or falls.

Economists tend to believe that some firms and workers fail to accurately predict changes
in the price level. This gives three potential explanations for why the SRAS curve is
upward- sloping:

 Contracts make some wages and prices “sticky”.

  Firms are often slow to adjust wages.
 Menu costs make some prices sticky.

Short-run Aggregate Supply

Contracts
 Contracts make some wages and prices “sticky.” Prices and wages are said to be
“sticky” when they do not respond quickly to changes in demand or supply.
 Some firms and workers fail to predict price level changes, and hence do not
correctly build them into long-term contracts.

Short-run Aggregate Supply:

Wage Adjustment
 Firms are often slow to adjust wages
 Salary reviews typically only happen annually.
 Also, firms dislike cutting wages—it’s bad for morale.

Short-run Aggregate Supply:

Menu Costs
 Firms have menu costs: the costs to firms of changing prices.
 A small “optimal” change in price may not be worth the hassle for a firm
to perform.

Shifts of the Short-run Aggregate Supply Curve

vs.
Movements along It
The short-run aggregate supply curve describes the relationship between the
price level and the quantity of goods and services firms are willing to supply,
holding constant all other variables that affect the willingness of firms to supply
goods and services.

 A change in the price level not caused by factors that would otherwise
affect short-run aggregate supply results in a movement along a
stationary SRAS curve.
 But some factors (labor force, capital stock, productivity, expected future
price level, workers & firms adjusting to incorrect estimations of price
level, & supply shocks) cause the SRAS curve to shift.

Variables That Shift the SRAS Curve:

Labor force or Capital Stock

An increase in … shifts the short-run because …

aggregate
supply curve …
the labor force or the more output can be
capital produced
stock at every price level.

An decrease in … shifts the short-run because …

aggregate
supply curve …
the labor force or the less output can be produced
capital at every price level.
stock
Variables That Shift the SRAS Curve:
Productivity
An increase in … shifts the short-run because …
aggregate
supply curve …

productivity costs of producing output fall.

An decrease in … shifts the short-run aggregate because …

supply curve …

productivity costs of producing output increases

Variables That Shift the SRAS Curve:
Expected Future Price Level

An increase in … shifts the short-run because …

aggregate
supply curve …

the expected future price workers and firms decrease

level wages and prices.

An Decrease in … shifts the short-run because …

aggregate
supply curve …

the expected future price workers and firms decrease

level wages and prices.

Variables That Shift the SRAS Curve:

Workers & Firms adjusting to incorrect estimation of
price

An increase in … because …
shifts the short-run
aggregate
supply curve …
workers and firms adjusting workers and firms increase
to having previously under wages and prices.
estimated the price level
(rare)

An decrease in … because …
shifts the short-run
aggregate
supply curve …
workers and firms adjusting workers and firms decrease
to having previously over wages and prices.
estimated the price level
(rare)

Variables That Shift the SRAS Curve:

 Supply shocks
An decrease in … shifts the short-run because …
aggregate
supply curve …

the expected price of an costs of producing output

important natural resource rise.

An increase in … shifts the short-run because …

aggregate
supply curve …

the expected price of an costs of producing output rise.

important natural resource

Short-run Equilibrium
Long-run Equilibrium
Short-Run Effects of a Decrease in Aggregate Demand
Short-Run and Long-Run Effects of a Decrease in

Aggregate Demand
Short-Run Effects of an Increase in Aggregate Demand
Short-Run and Long-Run Effects of a Increase in
Aggregate Demand
Short-Run Effects of a Negative Supply Shock
(stagflation)