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Understanding Aggregate Demand Dynamics

Apr 2, 2025

Aggregate Demand: Lesson Summary

Overview

  • Aggregate Demand (AD): Illustrates relationship between price level and spending by households, businesses, government, and other countries.
  • Components of AD are the same as those used in calculating real GDP via expenditures approach:
    • C: Consumption
    • I: Investments
    • G: Government spending
    • N: Net exports

Key Terms

  • Price Level: A measure capturing all economy prices, e.g., CPI or GDP deflator.
  • Aggregate Demand: Model showing relationship between price level and spending on real GDP, where lower price levels increase real GDP.
  • Change in AD: Shift of AD curve due to changes in its components not caused by price level changes.
  • Movement along AD: Change in output demanded due to price level change.
  • Interest-sensitive consumption: Spending in 'C' category affected by interest rates.
  • Real Wealth Effect: Change in consumer spending due to changes in price level affecting purchasing power.
  • Interest Rate Effect: Change in spending due to price level affecting interest rates.
  • Exchange Rate Effect: Price level changes leading to changes in exports and thus real GDP.
  • Fiscal Policy: Using taxes, spending, or transfers to influence real GDP.
  • Monetary Policy: Using money supply to affect interest rates and real GDP.

Key Takeaways

The AD Curve

  • Part of National Income Determination model.
  • Describes spending by households, firms, government, and world at varying price levels.

Why AD Slopes Down

  • AD slopes down as real GDP increases when price level decreases.
  • Three main effects causing slope:
    • Wealth Effect
    • Interest Rate Effect
    • Exchange Rate Effect

Shifts in Aggregate Demand

  • Changes in AD components (not price level) cause AD shifts.
  • Examples:
    • Consumption increase due to bonuses shifts AD right.
    • Interest rate hikes decreasing investment shifts AD left.
    • Export increase shifts AD right.

Digging Deeper

Wealth Effect

  • Price level drop increases purchasing power, thus increasing consumption and moving AD right.

Interest Rate Effect

  • Lower price levels decrease interest rates, increasing investment and consumption.
  • Higher price levels increase interest rates, decreasing consumption and investment.

Exchange Rate Effect

  • Lower price levels make exports more attractive, increasing net exports and real GDP.
  • Higher price levels make exports less attractive, decreasing net exports.

Key Graphical Model

The Aggregate Demand Curve

  • Shows inverse relationship between price level and spending on real GDP.
  • Example: Price level decrease from 120 to 102 increases output spending from $16T to $17T.

Common Misperceptions

  • AD relates price level with real GDP, not nominal GDP.
  • Determine whether it's an AD shift or movement by identifying if change is due to price level changes.
  • Avoid shortcuts in labeling graphs.

Discussion Questions

  • How does a change in consumer incomes affect the AD model graphically?
  • Difference between real interest rates change and interest rate effect?
  • List five factors that increase aggregate demand.