Aggregate Demand

Course Supervisor: Sheeba Tahir

Lecturer - KASBIT

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 Short-Run Economic Fluctuations
• Economic activity fluctuates from year to year.
• In most years production of goods and services
rises.
• On average over the past 50 years, production in the
U.S. economy has grown by about 3 percent per
year.
• In some years normal growth does not occur,
causing a recession.

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 Short-Run Economic Fluctuations
• A recession is a period of declining real
incomes, and rising unemployment.
• A depression is a severe recession.

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 THREE KEY FACTS ABOUT
ECONOMIC FLUCTUATIONS
• Economic fluctuations are irregular and
unpredictable.
• Fluctuations in the economy are often called the
business cycle.
• Most macroeconomic variables fluctuate
together.
• As output falls, unemployment rises.

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Figure 1 A Look At Short-Run Economic
Fluctuations

(a) Real GDP

Billions of
1996 Dollars
$10,000

9,000 Real GDP

8,000

7,000

6,000

5,000

4,000

3,000

2,000
1965 1970 1975 1980 1985 1990 1995 2000

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 THREE KEY FACTS ABOUT
ECONOMIC FLUCTUATIONS
• Most macroeconomic variables fluctuate
together.
• Most macroeconomic variables that measure some
type of income or production fluctuate closely
together.
• Although many macroeconomic variables fluctuate
together, they fluctuate by different amounts.

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Figure 1 A Look At Short-Run Economic
Fluctuations

(b) Investment Spending

Billions of
1996 Dollars

$1,800

1,600

1,400 Investment spending

1,200

1,000

800

600

400

200
1965 1970 1975 1980 1985 1990 1995 2000

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 THREE KEY FACTS ABOUT
ECONOMIC FLUCTUATIONS
• As output falls, unemployment rises.
• Changes in real GDP are inversely related to
changes in the unemployment rate.
• During times of recession, unemployment rises
substantially.

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Figure 1 A Look At Short-Run Economic
Fluctuations

(c) Unemployment Rate

Percent of
Labor Force
12

10

8 Unemployment rate

0
1965 1970 1975 1980 1985 1990 1995 2000

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 EXPLAINING SHORT-RUN
ECONOMIC FLUCTUATIONS
• How the Short Run Differs from the Long Run
• Most economists believe that classical theory
describes the world in the long run but not in the
short run.
• Changes in the money supply affect nominal variables
but not real variables in the long run.
• The assumption of monetary neutrality is not appropriate
when studying year-to-year changes in the economy.

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The Basic Model of Economic Fluctuations

• Two variables are used to develop a model to

analyze the short-run fluctuations.
• The economy’s output of goods and services
measured by real GDP.
• The overall price level measured by the CPI or the
GDP deflator.

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The Basic Model of Economic Fluctuations

• The Basic Model of Aggregate Demand and

Aggregate Supply
• Economist use the model of aggregate demand and
aggregate supply to explain short-run fluctuations
in economic activity around its long-run trend.

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The Basic Model of Economic Fluctuations

• The Basic Model of Aggregate Demand and

Aggregate Supply
• The aggregate-demand curve shows the quantity of
goods and services that households, firms, and the
government want to buy at each price level.

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The Basic Model of Economic Fluctuations

• The Basic Model of Aggregate Demand and

Aggregate Supply
• The aggregate-supply curve shows the quantity of
goods and services that firms choose to produce and
sell at each price level.

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 Figure 2 Aggregate Demand and Aggregate
Supply...

Price
Level

Aggregate
supply

Equilibrium
price level

Aggregate
demand

0 Equilibrium Quantity of
output Output

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 THE AGGREGATE-DEMAND
CURVE
• The four components of GDP (Y) contribute to
the aggregate demand for goods and services.
Y = C + I + G + NX

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 AGGREGATE DEMAND
• the aggregate expenditures model is a useful tool in determining
the equilibrium level of output in the economy. It does have a
significant flaw, however: the aggregate expenditures model
does not take into account the impact of the price level on
aggregate output.
• The Aggregate Demand Curve (AD) represents, in that sense,
an even more appropriate model of aggregate output, because it
shows the various amounts of goods and services which
domestic consumers (C), businesses (I), the government (G),
and foreign buyers (NX) collectively will desire at each
possible price level. Let’s begin by showing the relationship
between the aggregate expenditures model and the AD curve.

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 AGGREGATE DEMAND
• In the graph below, we show the standard aggregate
expenditures curve at three different price levels.
When prices are high (P1), Consumption is low; as
prices fall to P2 and P3, Consumption rises. As the
Consumption function shifts upward due to the falling
prices, the equilibrium level of GDP goes up from
GDP1 to GDP3. This is depicted in the AD framework
as a downward sloping AD curve.

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Figure 3 The Aggregate-Demand Curve...

Price
Level

P2
1. A decrease
Aggregate
in the price
demand
level . . .

0 Y Y2 Quantity of
Output
2. . . . increases the quantity of
goods and services demanded.

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Why the Aggregate-Demand Curve Is
Downward Sloping
• The Price Level and Consumption: The Wealth
Effect
• The Price Level and Investment: The Interest
Rate Effect
• The Price Level and Net Exports: The
Exchange-Rate Effect

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Why the Aggregate-Demand Curve Is
Downward Sloping
• The Price Level and Consumption: The Wealth
Effect
• A decrease in the price level makes consumers feel
more wealthy, which in turn encourages them to
spend more.
• This increase in consumer spending means larger
quantities of goods and services demanded.

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Why the Aggregate-Demand Curve Is
Downward Sloping
• The Price Level and Investment: The Interest
Rate Effect
• A lower price level reduces the interest rate, which
encourages greater spending on investment goods.
• This increase in investment spending means a larger
quantity of goods and services demanded.

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Why the Aggregate-Demand Curve Is
Downward Sloping
• The Price Level and Net Exports: The
Exchange-Rate Effect
• When a fall in the U.S. price level causes U.S.
interest rates to fall, the real exchange rate
depreciates, which stimulates U.S. net exports.
• The increase in net export spending means a larger
quantity of goods and services demanded.

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Why the Aggregate-Demand Curve Might
Shift
• The downward slope of the aggregate demand
curve shows that a fall in the price level raises
the overall quantity of goods and services
demanded.
• Many other factors, however, affect the
quantity of goods and services demanded at any
given price level.
• When one of these other factors changes, the
aggregate demand curve shifts.

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Why the Aggregate-Demand Curve Might
Shift
• Shifts arising from
• Consumption
• Investment
• Government Purchases
• Net Exports

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Rise in Government spending shifts
the Aggregate Demand Curve
Price
Level

P1

D2
Aggregate
demand, D1

0 Y1 Y2 Quantity of
Output
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 An Increase in the Taxes shift the
demand curve

Price
level

Y1

D1
D2

Quantity Out put

Y2 Y1
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 Consumption
• This is spending by households on good and
services to meet its wants.
• E.g. Food and Clothes or TV Service
• Influences – Disposable Income, the more
consumers have typically the higher AD –
Distribution of Income, an even distribution
causes a greater rise in AD – Availability of
Credit, is credit is cheap then AD rises, if not
AD falls

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 Investment
• Spending by Businesses on capital goods e.g.
Factories.
• • Influences
– Changes in income, as incomes rise, people demand
more so businesses invest to cope with demand
– Rate of Interest, a lower rate will stimulate investment
as the cost of borrowing is low
– Profit Level, if profits are expected to be high
– Government Policy, lower corporation tax etc

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 Government Spending
• Spending by Government
• Main areas are Social Security, Health,
Education and Defense
• Influences
– Public Opinion
– State of the Economy
– Market Failures

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 Net Export
• This is total exports (X) minus total imports
(M)
• Influences on Net Exports
– Domestic Income, if incomes are high we
tend to suck in imports, which lowers AD
– Foreign Income, if incomes in other countries
rise, they will suck in British Exports
– Exchange Rates if the currency is weak
against another then it will encourage exports
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 Money supply
• The AD curve assumes that money supply is
fixed.
• The decrease in the money supply is mirrored
by an equal decrease in the nominal output,
otherwise known as Gross Domestic Product
( GDP ).
• The decrease in the money supply will lead to a
decrease in consumer spending. This decrease
will shift the AD curve to the left.

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• The increase in the money supply is mirrored
by an equal increase in nominal output, or
Gross Domestic Product (GDP).
• The increase in the money supply will lead to
an increase in consumer spending. This
increase will shift the AD curve to the right.
• Increased money supply causes reduction in
interest rates and further spending and therefore
an increase in AD.

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 Table
Income Consumption Investment Aggregate Demand
(C+I)

0 40 40 80

100 120 40 160

200 200 40 240

300 280 40 320

400 360 40 400

500 440 40 480

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Income Consumpt Investmen Saving AD=C+I AS=C+S Out
ion t Come

0 40 40 -40 80 0 AD> AS

100 120 40 -20 160 100

200 200 40 0 240 200

300 280 40 20 320 300

400 360 40 40 400 400 AD=AS

500 440 40 60 480 500 AD<AS

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