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The  Aggregate  Demand-­‐-­‐ Aggregate  Supply  Model
Tuesday,   April  14,  2 015

4:36  PM

What  is  the  aggregate  demand-­‐aggregate  supply  model?

• Two  different  paths  of  study  in  macroecon
○ Explores  long-­‐run  growth  and  development
○ Examine  short-­‐run  fluctuations,  or  business  cycle
• Both  study  GDP  growth,  employment,  and  the  people,  firms,  and  gove
• Growth  economics  focus  on  longer  time  horizons
• Business-­‐cycle  theory  typically  focuses  on  time  horizons  of  5  years  of  l
• The  model  we  use  to  study  business  cycles  is  the  aggregate  demand-­‐a
○ Now  we  look  at  the  final  goods  and  services  in  an  economy-­‐-­‐the  d
○ Aggregate  Demand: the  total  demand  for  final  goods  and  services
○ Aggregate  Supply: the  total  supply  of  final  goods  and  services  in  a
○ THE  WORD  AGGREGATE  MEANS  TOTAL
What  is  Aggregate  Demand?

• Aggregate  demand  is  the  spending  side  of  the  economy
○ AD  increases  when  people  spend  on  goods  and  services  and  most
• To  determine  aggregate  demand  we  sum  up  spending  from  different  s
○ AD  =  C  +  I  +  G  +  NX
• On  the  AD  curve
○ Horizontal  axis:  plot  quantities  of  all  final  goods  and  services,  whi
○ Vertical  axis:  General  price  level  of  the  whole  economy
§ Use  the  GDP  deflator
○ The  negative  slope  means  that  increases  in  the  price  level  lead  to
The  Slope  of  the  Aggregate  Demand  Curve

ernments  that  impact  the  economy

less
aggregate  supply  model
demand  and  supply  of  GDP
s  in  an  economy
an  economy

t  people  believe  that  this  spending  is  what  drives  the  economy
source  in  the  economy

ich  constitute  real  GDP

o  decreases  in  the  quantity  of  aggregate  demand

§ Use  the  GDP  deflator
○ The  negative  slope  means  that  increases  in  the  price  level  lead  to
The  Slope  of  the  Aggregate  Demand  Curve

• All  else  being  equal:  increases  in  the  economy's  price  level  leads  to  de
• Substitutions  from  one  market  to  another  have  no  effect  on  the  total  
• Three  reasons  for  this  inverse  relationship
○ The  Wealth  Effect
§ Wealth: the  value  of  one's  accumulated  assets
§ Wealth  is  the  total  value  of  everything  you  own,  including  th
§ Wealth  effect: is  the  change  in  the  quantity  of  aggregate  dem
§ A  rise  in  prices  all  over  the  economy  reduces  real  wealth  in  t
§ If  prices  fall,  real  wealth  increases,  and  then  the  quantity  of  a
○ The  Interest  Rate  Effect
§ If  the  price  level  rises  and  real  wealth  falls,  people  save  less
§ When  you  cut  back  on  groceries  that  shows  the  effect  of  the
§ When  you  cut  back  on  your  savings  that  shows  the  effect  of  
§ Interest  Rate  Effect: occurs  when  a  change  in  the  price  level  
demand
§ When  savings  declines,  the  quantity  of  investment  must  also
□ It’s  a  reduction  in  the  supply  of  savings  that  makes  the  i
(horizontal  axis)
○ The  International  Trade  Effect
§ The  price  level  and  real  GDP  represent  the  domestic  market
§ We  must  also  consider  the  prices  of  the  US  relative  to  the  pr
§ When  the  US  price  level  rises,  all  else  equal,  US  goods  are  re
§ International  Trade  Effect: a  change  in  the  price  level  leads  to
• All  three  reasons  work  together  to  influence  the  quantity  of  aggregate
○ Begins  with  a  change  in  the  price  level
○ Consumption  (  C  )  decreases  from  the  wealth  effect
○ Investment  (I)  declines  from  the  interest  rate  effect
○ Net  exports  (NX)  declines  due  to  the  international  trade  effect
• All  three  do  not  influence  AD  equally

o  decreases  in  the  quantity  of  aggregate  demand

ecreases  in  the  quantity  of  aggregate  demand
amount  of  output,  or  real  GDP

he  money  in  your  wallet  and  in  your  bank  accounts
mand  that  results  from  wealth  changes  due  to  price-­‐level  changes
the  economy  and  then  the  quantity  of  aggregate  demand  falls
aggregate  demand  also  increases

e  wealth  effect
 the  interest  rate  effect
 leads  to  a  change  in  interest  rates  and  therefore  in  the  quantity  of  aggregate  

o  decline,  which  affects  aggregate  demand
interest  rate  increase  (vertical  axis)  and  the  quantity  of  investment  decrease  

rices  of  other  countries
elatively  more  expensive  and  so  the  quantity  demanded  for  US  goods  decreases
o  a  change  in  the  quantity  of  net  exports  demanded
e  demand

○ Consumption  (  C  )  decreases  from  the  wealth  effect
○ Investment  (I)  declines  from  the  interest  rate  effect
○ Net  exports  (NX)  declines  due  to  the  international  trade  effect
• All  three  do  not  influence  AD  equally
○ NX  is  a  very  small  part  of  GDP
○ Consumption  is  the  most  important  part  because  it  is  the  largest
• These  are  the  factors  that  produce  MOVEMENT  along  the  aggregate  d
○ NOT  SHIFTS
Shifts  in  Aggregate  Demand

• Real  Wealth
○ Determinate  of  people's  spending  habits
○ When  national  wealth  increases,  AD  increases
§ If  wealth  falls,  AD  decreases
○ Stock  market  and  real  estate  prices  are  examples
○ This  is  changes  in  individuals  real  wealth  NOT  caused  by  changes  
• Expected  Income
○ Expecting  higher  income  in  the  future:  spend  more  today
○ consumer  confidence  or  consumer  sentiment  index:  uses  survey
○ Ex

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