1. AGGREGATE
DEMAND:
INTRODUCTION AND
DETERMINANTS
MODULE 17

2. AGGREGATE DEMAND
• The aggregate demand curve shows the
relationship between the aggregate price
level and the quantity of aggregate
output demanded by
households, businesses, the
government, and the rest of the world.
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3. AGGREGATE DEMAND
• The horizontal axis shows the total
quantity of domestic goods and services
demanded, measured in real dollars.
• Real GDP is used to measure aggregate
output and either term can be used.
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4. AGGREGATE DEMAND
• The vertical axis shows the aggregate
price level, measured by the GDP
deflator.
• The AD (aggregate demand) curve
shows how much aggregate output
would be demanded at any given price
level.
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5. AGGREGATE DEMAND
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6. AGGREGATE DEMAND
• The aggregate demand curve is downward
sloping, indicating a negative relationship
between the aggregate price level and the
quantity of aggregate output demanded.
• A higher aggregate price level reduces the
quantity of aggregate output demanded; a
lower aggregate price level increases the
quantity of aggregate output demanded.
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7. AGGREGATE DEMAND
1. It shows an inverse relationship
between price level and domestic
output.
2. The explanation of the inverse
relationship is not the same as for
demand for a single product, which
centered on substitution and income
effects.
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8. AGGREGATE DEMAND
a. Substitution effect doesn’t apply in the
aggregate case, since there is no
substitute for “everything.”
b. Income effect also doesn’t apply in the
aggregate case, since income now
varies with aggregate output.
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9. AGGREGATE DEMAND
• The Law of Demand does not explain
why the AD curve is downward sloping.
• When we consider movements up or
down the AD curve, we are considering
a simultaneous change in the prices of
all final goods and services.
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10. WHY IS AGGREGATE DEMAND
DOWNSLOPING?
There are two main reasons why a rise in the
aggregate price level leads to a fall in the
quantity of all domestically produced final
goods and services demanded:
1. The Wealth Effect: The change in consumer
spending caused by the altered purchasing
power of consumer’s assets.
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11. WHY IS AGGREGATE DEMAND
DOWNSLOPING?
• An increase is the aggregate price level, other
things equal, reduces the purchasing power of
many assets, leading to a fall in spending on
final goods and services, because a rise in the
aggregate price level reduces the purchasing
power of everyone.
• Correspondingly, a fall in the aggregate price
level increases the purchasing power of
consumer’s assets and leads to more consumer
demand.
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12. WHY IS AGGREGATE DEMAND
DOWNSLOPING?
• So the wealth effect of a change in the
aggregate price level causes consumer
spending to fall when the aggregate price level
rises and to rise when the aggregate price
level falls.
• This leads to a downward sloping aggregate
demand curve.
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13. WHY IS AGGREGATE DEMAND
DOWNSLOPING?
2. The Interest Rate Effect: People and firms
hold money because it reduces the cost and
inconvenience of making transactions.
• When the aggregate price level
increases, other things equal, this reduces the
purchasing power of the money holdings, so
people need to hold more money to be able to
purchase the same basket of goods and
services as before.
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14. WHY IS AGGREGATE DEMAND
DOWNSLOPING?
• So, the public tries to increase their holding of
money by borrowing or by selling assets such
as bonds.
• This reduces the amount of funds available for
lending to other borrowers and drives the
interest rates up.
• A rise in the interest rate reduces investment
spending because it makes the cost of
borrowing higher and reduces consumer
spending because households will now save
more of their disposable income.
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15. WHY IS AGGREGATE DEMAND
DOWNSLOPING?
• So a rise in the aggregate price level depresses
investment spending, I, and consumer
spending, C, through its effect on the
purchasing power of money holdings, through
the effect of the interest rate effect of a
change in the aggregate price level.
• This leads to a downward sloping aggregate
demand curve.
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16. WHY IS AGGREGATE DEMAND
DOWNSLOPING?
3. Foreign purchases effect: When price level
falls, other things being equal, U.S. prices
will fall relative to foreign prices, which will
tend to increase spending on U.S. exports
and also decrease import spending in favor
of U.S. products that compete with imports.
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17. DETERMINANTS OF
AGGREGATE DEMAND
• A movement along the aggregate demand
curve is a change in the quantity of goods and
services demanded at any given price level.
• When aggregate demand changes, this is
shown as a shift in the aggregate demand
curve.
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18. DETERMINANTS OF
AGGREGATE DEMAND
• An increase in aggregate demand, means a
shift of the aggregate demand curve to the
right.
• This rightward shift occurs when the quantity
of aggregate output demanded increases at
any aggregate price level.
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19. DETERMINANTS OF
AGGREGATE DEMAND
• A decrease in aggregate demand means a shift
of the aggregate demand curve to the left.
• This leftward shift occurs when the quantity
of aggregate output demanded decreases at
any aggregate price level.
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20. DETERMINANTS OF
AGGREGATE DEMAND
• The most important factors that can shift the
aggregate demand curve are:
1. Changes in expectations
2. Changes in wealth
3. Size of the existing stock of physical capital
4. Fiscal policy
5. Monetary policy
• All five factors set the multiplier process in
motion.
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21. DETERMINANTS OF
AGGREGATE DEMAND
Initial rise or fall in real GDP
Change disposable income
Additional changes in consumer
spending
Further changes in real GDP
…and so on…
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22. FACTORS THAT SHIFT THE
AGGREGATE DEMAND CURVE
Changes in • If consumers and firms become more optimistic, AD increases
Expectations • If consumers and firms become more pessimistic, AD decreases.
• If the real value of household assets rises, AD increases
Changes in Wealth • If the real value of household assets falls, AD decreases
Size of the Existing • If the existing stock of physical capital is relatively small, AD
increases
Stock of Physical • If the existing stock of physical capital is relatively large, AD
Capital decreases
• If government increases spending or cuts taxes, AD increases
Fiscal Policy • If government reduces spending or raises taxes, AD decreases
• If the central bank increases the quantity of money, AD increases
Monetary Policy • If the central bank reduces the quantity of money, AD decreases
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23. FISCAL POLICY
• Fiscal Policy is the use of government
spending or tax policy to stabilize the
economy.
• Government will respond to recessions by
increasing government purchases of final
goods and services or by cutting taxes, or
both.
• They respond to inflation by reducing their
spending or by increasing taxes, or both.
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24. FISCAL POLICY
• The effect government purchases of final
goods and services, G, on the aggregate
demand curve is direct because G is a
component of aggregate demand.
• The effect of changes in tax rates or
government transfers on aggregate demand is
indirect through their effect on disposable
income. (higher taxes reduce DI and lower
taxes increase DI)
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25. MONETARY POLICY
• Monetary Policy is the central bank’s use of
changes in the quantity of money or the
interest rate to stabilize the economy.
• Increasing the amount of money reduces the
interest rate and boost aggregate demand.
• Decreasing the amount of money increases the
interest rate and depresses aggregate demand.
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