Unit 3: Aggregate Demand

Aggregate Demand (AD): shows the amount of real GDP that the private, public, and foreign sector collectively desire to purchase at each possible price level; the demand by consumers, businesses, government, and foreign countries


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  • the inverse relationship between price level and real GDP level
  • AD = C + I + G + Xn
  • Curve X Axis: real domestic output
  • Curve Y Axis: price level
  • Changes in price level cause a move along the curve not a shift of the curve

3 Reasons Why AD is Downward Sloping: 

1. The Wealth Effect
  • Higher prices reduce the purchasing power of $
  • This decreases the quantity of expenditures
  • Lower price levels increase purchasing power and increase expenditures
  • Ex: If the balance in your bank was $50,000 but inflation erodes your purchasing power, you will be likely to reduce your spending
  • Price level goes up, GDP demanded goes down
2. The Interest-Rate Effect 
  • As price level increases, lenders need to charge higher interest rates to get a real return on their loans
  • Higher interest rates discourage consumer spending and business investment 
  • Ex: Increase in prices leads to an increase in the interest rate from 5% to 25%. You are less likely to take out loans to improve your business. 
  • Price Level goes up, GDP demanded goes down (and vice versa)
3. The Foreign Trade Effect
  • When U.S price level rises, foreign buyers purchase fewer U.S goods and Americans buy more foreign goods
  • Exports fall and imports rise causing real GDP demanded to fall (Xn decreases)
  • Example: If prices triple in the US, Canada will not longer buy U.S goods causing quantity demanded of U.S products to fall

Shifts in Aggregate Demand (AD)

There are two parts to a shift in AD:

  • A change in C, Ig, G, and/or Xn
  • A multiplier effect that produces a greater change than the original 

Determinants of AD: 
  • Consumption (C) 
  • Gross Private Investment (Ig) 
  • Government Spending (G) 
  • Net Exports (Xn) = Exports - Imports (X-M)

1. Change in Consumer Spending
  • Consumer Wealth (Boom in the stock market) 
  • Consumer Expectations (People fear a recession)
  • Household Indebtedness (More consumer debt)
  • Taxes (Decrease in income taxes)

2. Change in Investment Spending 
  • Real Interest Rates (Price of borrowing $) 
  •                                (If interest rates increase)
  •                                (If interest rates decrease) 
  • Future Business Expectations (High expectations) 
  • Productivity and Technology (New robots) 
  • Business Taxes (Higher corporate taxes means)
3. Change in Government Spending
  • War
  • Nationalized Health Care
  • Decrease in Defense Spending 
4. Change in Net Exports (X - M)
  • Exchange Rates (If the US dollar depreciates relative to the euro)
  • National Income Compared to Abroad (If a major importer has a recession; if the US has a recession) 
  • "If the US gets a cold, Canada gets Pneumonia"
AD = GDP = C + I + G + Xn

5. Government Spending 
  • more government spending (AD →) 
  • less government spending (AD ←)


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