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.