Unit 3 Notes - February 12th, 2016

Aggregate Demand (AD): The demand by consumers, businesses, the government, and foreign countries. [Aggregate Demand Curve]

·         What definitely doesn’t shift the curve?

·         Changes in price level cause a move along the curve.

Why is Aggregate Demand Downward sloping?

·         The Real-Balance Effect:

o   Higher price levels reduce the purchasing power of money.

o   This decreases the quantity of expenditures.

o   Lower price levels increase purchasing power and increase expenditures.

Example: If the balance in your bank was $50,000, but the inflation erodes your purchasing power, you will likely reduce your spending.

·         The Interest-Rate Effect:

o   When the price levels increases, lenders need to charge higher interest rates to get a REAL return on their loans.

o   Higher interest rates discourage spending and business investments.

·         The Foreign-Trade Effect:

o   When U.S. price levels rise, foreign buyers purchase fewer U.S. goods and Americans buy more foreign goods.

o   Exports fall and imports rise causing real GDP demand to fall. (Net Exports, Xn, Decreases)

Two Parts to a Shift in AD

·         Change in C, G, Ig, or Xn

·         A Multiplier effect that produces a greater change than the original change in the four components.

Increases in AD = AD shifting to the right. 

Decreases in AD = AD shifting to the left. 

Determinants of Aggregate Demand (AD)

·         Consumption (C)

o   Household spending is affected by:

§  Consumer Wealth:

·         More Wealth = More Spending. [AD Shifts Right]

·         Less Wealth = Less Spending. [AD Shifts Left]

§  Consumer Expectations:

·         Positive = More Spending. [AD Shifts Right]

·         Negative = Less Spending. [AD Shifts Left]

§  Household Indebtedness:

·         Less Debt = More Spending. [AD Shifts Right]

·         More Debt = Less Spending. [AD Shifts Left]

§  Taxes:

·         Less Taxes = More Spending. [AD Shifts Right]

·         More Taxes = Less Spending. [AD Shifts Left]

·         Gross Private Investment (Ig)

o   Investment spending is sensitive to:

§  The Real-Interest Rate:

·         Lower Real-Interest Rate = More Investment. [AD Shifts Right]

·         Higher Real-Interest Rate = Less Investment [AD Shifts Left]

§  Expected Returns:

·         Expected Returns are influenced by:

o   Expectations of future profitability

o   Technology

o   Degree of excess capacity (Existing stock capital)

o   Business Taxes

·         Higher Expected Returns = More [AD Shifts Right]

·         Lower Expected Returns = Less [AD Shifts Left]

·         Government Spending (G)

§  More Spending = AD Shifts Right

§  Less Spending = AD Shifts Left

·         Net Exports (Xn)

o   Net Exports are sensitive to:

§  Exchange Rates (International Value of Money):

·         Strong Money = More imports; Fewer exports. [AD Shifts Left]

·         Weak Money = Less imports; Fewer exports. [AD Shifts Right]

§  Relative Income:

·         Strong Foreign Economics = More Exports [AD Shifts Right]

·         Weak Foreign Economics =  Less Exports [AD Shifts Left]