Aggregate Demand and Aggregate Supply Model

Introduction

• Focus on understanding the Aggregate Demand (AD) and Aggregate Supply (AS) model.
• Aggregate Demand is the total real GDP that all buyers in an economy can purchase when all else is constant.

Components of Aggregate Demand

1. Consumer Spending (C)
2. Investment Spending (IG)
   • From firms.
3. Government Spending (G)
4. Foreign Sector
   • Net Exports (X).

• Aggregate Demand formula: AD = C + IG + G + X.

Understanding the AD Curve

• Price Level: Vertical Axis.
• Real GDP: Horizontal Axis.
• AD curve is downward sloping.

Reasons for Downward Slope in AD

1. Real Balance Effect

   • Price level changes affect purchasing power.
   • Higher price levels decrease purchasing power and real GDP demanded.

2. Interest Rate Effect

   • Price level increases -> need more money -> demand for money increases -> interest rates rise -> consumption falls.

3. Foreign Purchase Effect

   • Higher domestic prices -> substitution with foreign goods -> decrease in domestic GDP demanded.

Shifts in Aggregate Demand

• AD can increase or decrease.
• Determinants causing shifts:

Determinants of Aggregate Demand

Consumption Factors

1. Wealth Effect

   • Changes in wealth affect consumption and shift AD.
   • Example: Market crash decreases wealth and consumption.

2. Borrowing

   • Increased borrowing boosts consumption and AD.
   • Influenced by interest rates.

3. Expectations

   • Future income or price expectations affect current spending.

4. Personal Taxes

   • Higher taxes reduce disposable income and consumption, shifting AD left.

Investment Factors

1. Expected Rate of Returns (ERR)

   • Changes in ERR influence investment.

2. Operating Costs

   • Higher costs decrease ERR and AD.

3. Business Taxes

   • Increased taxes reduce ERR and shift AD left.

4. Business Expectations

   • Positive expectations boost ERR and AD.

5. Existing Capital

   • Excess capacity reduces ERR and investment.

6. Technological Changes

   • New tech increases ERR and AD.

Government Purchases

• Increased government spending rises AD.

Net Exports

1. National Income Abroad

   • Higher foreign income increases exports and AD.

2. Exchange Rates

   • Dollar depreciation increases exports and AD.

3. Tariffs

   • Short-term increase in AD, but potential long-term negative effects due to retaliations.

Conclusion

• AD is influenced by multiple factors from consumption, investment, government, and net exports.
• Changes in any of these factors determine shifts in the aggregate demand.