Aggregate demand

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Intros
Lessons
  1. Aggregate Demand Definitions
    • Quantity of real GDP Demanded
    • Total amount of final goods and services
    • Aggregate Demand
  2. Aggregate Demand Curve
    • Downward sloping
    • Price Level vs. Real GDP Demanded
    • Wealth Effect
    • Substitution Effect
  3. Shifts & Changes in Aggregate Demand
    • Future Expectations
    • Monetary Policy
    • Fiscal Policy
    • Exchange Rate
    • Foreign Income
Topic Notes
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Aggregate Demand Definitions

Quantity of Real GDP Demanded: is the sum of all consumption expenditure, investment, government expenditure, and exports subtracted by imports. In other words,

Y=C+I+G+(XM)Y=C+I+G+(X-M)

It is the total amount of final goods and services produced in a country, which households, firms, governments, and foreigners consider buying, valued in dollars (2005).

Aggregate Demand: the relationship between the price level and quantity of real GDP demanded.

Unlike aggregate supply, aggregate demand is the same for short-run and long-run.

Aggregate Demand Curve

The following graph shows the Aggregate Demand Curve.

Aggregate Demand


In the graph, we see that
  1. Price level \, \uparrow \, \, real GDP demanded\, \downarrow
  2. Price level \, \downarrow \, \, real GDP demanded \, \uparrow
  3. Downward sloping line (positive slope)


Why is the curve downward sloping? There are two reasons.

  1. Wealth Effect: When price level increases, real wealth decreases. People will try to restore their wealth by saving more and consuming less. Since consumption has decreased, the real GDP demanded also decrease.
  2. Substitution Effect: When price level increases, other things staying the same, the interest rate will also increase. An increase in price level decreases the value of money that people are holding. People have an incentive to take loans out, even if the interest rate is high (which banks take advantage of).

    Due to the high interest rate, people delay their plans to buy capital, goods, and spend less so that they can save more for future consumption, thus decreasing real GDP demanded.


Shifts & Changes in Aggregate Demand

There are five influences that shifts the aggregate demand curve.

Aggregate Demand


  1. Future Expectations: when people expect a higher income in the future, they tend to buy more consumption goods today.
    1. If future income, inflation, or profit increases, then aggregate demand increases (right shift).
    2. If future income, inflation, or profit decreases, then aggregate demand decreases (left shift).

  2. Monetary Policy: is when the Fed tries to influence the economy by changing interest rates and money quantity.
    1. money quantity \, \uparrow \, \, interest rates \, \downarrow \, \, loans \, \uparrow \, \, investments \, \uparrow \, \, aggregate demand increases (right shift).
    2. money quantity \, \downarrow \, \, interest rates \, \uparrow \, \, loans \, \downarrow \, \, investments \, \downarrow \, \, aggregate demand decreases (right shift).

  3. Fiscal Policy: is when government tries to influence the economy through changes in tax, transfer payments, or purchases of goods and services.
    1. If government expenditures or transfer payments increases, or tax decreases, then aggregate demand increases (right shift).
    2. If government expenditures or transfer payments decreases, or tax increases, then aggregate demand decreases (left shift).

  4. Exchange Rate: is the amount of foreign currency one can buy with a US dollar.
    1. If exchange rate increases, then aggregate demand decreases (left shift).
    2. If exchange rate decreases, then aggregate demand increases (right shift).

  5. Foreign Income: is income earned from foreign countries
    1. Foreign income \, \uparrow \, \, exports \, \uparrow \, \, aggregate demand increases (right shift).
    2. Foreign income \, \downarrow \, \, exports \, \downarrow \, \, aggregate demand decreases (left shift).