Exploring Economics - 4e - Chapter 25.pdf - po ang - Januszek66

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CHAPTER

A GGREGATE D EMAND AND

A GGREGATE S UPPLY

25.1

The Determinants of Aggregate Demand

25.4

The Aggregate Supply Curve

25.2

The Aggregate Demand Curve

25.5

Shifts in the Aggregate Supply Curve

25.3

Shifts in the Aggregate Demand Curve

25.6

Macroeconomic Equilibrium

n this chapter, we develop the aggregate

demand and aggregate supply model. The AD/AS

model is a variable price model; that is, it allows

us to see changes in the price level and changes

in real GDP simultaneously. We explain changes in

the price level and real GDP in both the short run

and long run. This model will help us understand

such key macroeconomic variables as inﬂation,

unemployment, and economic growth. In the fol-

lowing chapters, we will also use this model to help

us understand how stabilization policies can help

with problems that result from recession and

inﬂationary expansion.

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SECTION

25.1 The Determinants of Aggregate Demand

What is aggregate demand?

What is consumption?

What is investment?

What are government purchases?

What are net exports?

WHAT IS AGGREGATE DEMAND?

Aggregate demand (AD) is the sum of the demand

for all ﬁnal goods and services in the economy. It can

also be seen as the quantity of real gross domestic

product demanded at different price levels. The four

major components of aggregate demand are consump-

tion ( C ), investment ( I ),

government purchases

( G ), and net exports

( X

aggregate demand

(AD)

the total demand for all the ﬁnal

goods and services in the economy

M ). Aggregate

demand, then, is equal to

( X

M ).

CONSUMPTION (C )

Consumption is by far the largest component in aggre-

gate demand. Expenditures for consumer goods and

services typically absorb almost 70 percent of total eco-

nomic activity, as measured by GDP. Understanding the

determinants of consumption, then, is critical to an

understanding of the forces leading to changes in

aggregate demand, which, in turn, change total output

and income.

GOVERNMENT PURCHASES (G)

Government purchases, another component of aggre-

gate demand, include spending by federal, state, and

local governments for the purchase of new goods and

services produced. Most of the purchases at the fed-

eral level are for the military. In 2004, the federal gov-

ernment accounted for roughly 19 percent of total

spending. Government purchases at the state and local

levels include education, highways, and police protec-

tion. Although volatile shifts in government purchases

are less frequent than volatile shifts in investment

spending, they do occasionally occur, often at the

beginning or end of wars.

INVESTMENT (I )

Because investment spending (purchases of invest-

ment goods) is an important component of aggregate

demand, which in turn is a determinant of the level of

GDP, changes in investment spending are often

responsible for changes in the level of economic activ-

ity. If consumption is determined largely by the level

of disposable income, what determines the level of

investment expenditure? As you may recall, invest-

ment expenditure is the most unstable category of

GDP; it is sensitive to changes in economic, social,

and political variables. In 2004, investment was

roughly 16 percent of GDP.

Many factors are important in determining the

level of investment. Good business conditions “induce”

ﬁrms to invest because a healthy growth in demand for

products in the future seems likely, based on current

experience. We will consider the key variables that

inﬂuence investment spending in the next section.

NET EXPORTS (X M)

The interaction of the U.S. economy with the rest of

the world is becoming increasingly important. Up to

this point, for simplicity, we have not included the

foreign sector. However, international trade must be

incorporated into the

framework. Models that

include the effects of

international trade are

called open economy

models.

open economy

a type of model that includes inter-

national trade effects

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Aggregate Demand and Aggregate Supply

CHAPTER 25

Remember, exports

are goods and services

that we sell to foreign

customers, such as

movies, wheat, and Ford

Mustangs; imports are

goods and services that we buy from foreign compa-

nies, such as BMWs, French wine, and Sony TVs.

Exports and imports can alter aggregate demand.

Exports minus imports is what we call net exports.

If exports are greater than imports ( X

M ) on aggregate

demand is similar to the impact of government pur-

chases on aggregate demand. Suppose that the United

States has no trade surplus and no trade deﬁcit—zero

net exports. What would happen if foreign consumers

started buying more U.S. goods and services, while

U.S. consumers continued to buy imports at roughly

the same rate? The result would be positive net

exports ( X

The impact of net exports ( X

net exports

the difference between the value of

exports and the value of imports

M ) and greater demand for U.S. goods

and services—a higher level of aggregate demand.

What if a country has a trade deﬁcit? Assuming,

again, that the economy initially has zero net exports,

a trade deﬁcit, or negative net exports ( X

M ), we have

positive net exports. If imports are greater than

exports ( X

M ), net exports are negative.

M ), would

lower U.S. aggregate demand , ceteris paribus .

SECTION * CHECK

1. Aggregate demand is the sum of the demand for all ﬁnal goods and services in the economy. It can also be seen as

the quantity of real GDP demanded at different price levels.

2. The four major components of aggregate demand are consumption (C), investment (I ), government purchases (G),

and net exports (X M). Aggregate demand, then, is equal to C I G (X M).

3. Changes in investment spending are often responsible for changes in the level of economic activity.

4. Government purchases are made up of federal, state, and local purchases of goods and services.

5. Trade deﬁcits lower aggregate demand, other things being equal; trade surpluses increase aggregate demand, other

things being equal.

1. What are the major components of aggregate demand?

2. How would an increase in personal taxes or a decrease in transfer payments affect consumption?

3. What would an increase in exports do to aggregate demand, other things being equal? An increase in imports?

An increase in both imports and exports, where the change in exports was greater in magnitude?

SECTION

25.2 The Aggregate Demand Curve

How is the aggregate demand curve differ-

ent from the demand curve for a particular

good?

Why is the aggregate demand curve down-

ward sloping?

The aggregate demand curve reﬂects the total

amount of real goods and services that all groups

together want to pur-

chase in a given period.

In other words, it indi-

cates the quantities of

real gross domestic

product demanded at

different price levels.

Note that this is different

from the demand curve for a particular good presented

in Chapter 4, which looked at the relationship between

the relative price of a good and the quantity demanded.

aggregate demand

curve

graph that shows the inverse

relationship between the price level

and RGDP demanded

HOW IS THE QUANTITY OF REAL GDP DEMANDED

AFFECTED BY THE PRICE LEVEL?

The aggregate demand curve slopes downward,

which means an inverse (or opposite) relationship

exists between the price level and real gross domestic

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Macroeconomic Foundations

MODULE 6

In the event that the price level falls, the reverse

would hold true. A falling price level would

increase the real value of your cash assets, increas-

ing your purchasing power and increasing RGDP

demanded. The connection can be summarized as

follows:

SECTION 25.2

E XHIBIT 1

The Aggregate Demand Curve

PL 2

↑

Price level

⇒↓

Real wealth

⇒↓

Purchasing power

⇒↓

RGDP demanded

PL 1

and

↓

Price level

⇒↑

Real wealth

⇒↑

Purchasing power

⇒↑

RGDP demanded

RGDP 2

RGDP 1

Real GDP

The Interest Rate Effect

If the price level falls, households and ﬁrms will

need to hold less money to conduct their day-to-day

activities. Firms will need to hold less money for

such inputs as wages and taxes; households will

need to hold less money for such purchases as food,

rent, and clothing. At a lower price level, house-

holds and ﬁrms will shift their “excess” money into

interest-earning assets such as bonds or savings

accounts. This will increase the supply of funds to

the loanable funds market, leading to lower interest

rates. As interest rates fall, households and ﬁrms will

borrow more and buy more goods and services—

thus, the quantity of RGDP demanded will increase.

In sum:

The aggregate demand curve slopes downward,

reﬂecting an inverse relationship between the overall

price level and the quantity of real GDP demanded.

When the price level increases, the quantity of RGDP

demanded decreases; when the price level decreases,

the quantity of RGDP demanded increases.

product (RGDP) demanded. Exhibit 1 illustrates this

relationship, where the quantity of RGDP demanded

is measured on the horizontal axis and the overall

price level is measured on the vertical axis. As we

move from point A to point B on the aggregate

demand curve, we see that an increase in the price

level causes RGDP demanded to fall. Conversely, if a

reduction in the price level occurs—a movement from

B to A—RGDP demanded increases. Why do pur-

chasers in the economy demand less real output when

the price level rises and more real output when the

price level falls?

Households and

ﬁrms reduce their holdings of money and

save more

↓

Price level

⇒

Supply of loanable funds

increases

Households and

ﬁrms are encouraged to borrow and

spend

⇒

Interest rates fall

⇒

RDP demanded increases

WHY IS THE AGGREGATE DEMAND

CURVE NEGATIVELY SLOPED?

Three complementary explanations exist for the nega-

tive slope of the aggregate demand curve: the real

wealth effect, the interest rate effect, and the open

economy effect.

If the price level rises, households and ﬁrms will

need to hold more money to buy goods and services

and conduct their daily activities. Households and

ﬁrms will need to borrow money, and this increased

demand for loanable funds will result in higher

interest rates. At higher interest rates, consumers

may give up plans to buy new cars or houses, and

ﬁrms may delay investments in plant and equipment.

In sum:

The Real Wealth Effect

If you had $1,000 in cash stashed under your bed while

the economy suffered a serious bout of inﬂation, the

purchasing power of your cash would be eroded by the

extent of the inﬂation. That is, an increase in the price

level reduces real wealth and would consequently

decrease your planned purchases of goods and services,

lowering the quantity of RGDP demanded.

Households and ﬁrms

increase their holdings of money

↑

Price level

⇒

Demand

for loanable funds increases

⇒

Interest rates rise

⇒

Households and ﬁrms are discouraged from

borrowing and spending

⇒

RDP demanded

decreases

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Aggregate Demand and Aggregate Supply

CHAPTER 25

The Open Economy Effect

will stop buying U.S. goods. U.S. exports will fall and

U.S. imports will rise. Thus, net exports will fall,

thereby reducing the amount of RGDP purchased in the

United States. A lower price level makes U.S. exports

less expensive and foreign imports more expensive. So

U.S. consumers will buy more domestic goods, and for-

eign consumers will buy more U.S. goods. This will

increase net exports, thereby increasing the amount of

RGDP purchased in the United States.

Many goods and services are bought and sold in global

markets. If the price level in the United States rises rela-

tive to the price level in other countries, U.S. exports

will become relatively more expensive and foreign

imports will become relatively less expensive. Some U.S.

consumers will shift from buying domestic goods to

buying foreign goods (imports). Some foreign consumers

SECTION * CHECK

1. An aggregate demand curve shows the inverse relationship between the amounts of real goods and

services (RGDP) that are demanded at each possible price level.

2. The aggregate demand curve is downward sloping because of the real wealth effect, the interest rate

effect, and the open economy effect.

1. Why is the aggregate demand curve downward sloping?

2. How does an increased price level reduce the quantities of investment goods and consumer durables

demanded?

3. What is the real wealth effect, and how does it imply a downward-sloping aggregate demand curve?

4. What is the interest rate effect, and how does it imply a downward-sloping aggregate demand curve?

5. What is the open economy effect, and how does it imply a downward-sloping aggregate demand curve?

SECTION

25.3 Shifts in the Aggregate Demand Curve

What is the difference between a move-

ment along and a shift in the aggregate

demand curve?

What variables shift the aggregate demand

curve to the right?

What variables shift the aggregate demand

curve to the left?

SHIFTS VERSUS MOVEMENTS ALONG

THE AGGREGATE DEMAND CURVE

Like the supply and demand curves described in

Chapter 4, the aggregate demand curve may experi-

ence both shifts and movements. In the previous sec-

tion, we discussed three factors—the real wealth

effect, the interest rate effect, and the open economy

effect—that result in the downward slope of the

aggregate demand curve. Each of these factors, then,

generates a movement along the aggregate demand

curve, in reaction to changes in the general price level.

In this section, we will discuss some of the many fac-

tors that can cause the aggregate demand curve to

shift to the right or left.

The whole aggregate demand curve can shift to the

right or left, as shown in Exhibit 1. Put simply, if some

nonprice level determinant causes total spending to

increase, the aggregate demand curve will shift to the

right. If a non-price level determinant causes the level of

total spending to decline, the aggregate demand curve

will shift to the left. Let’s look at some speciﬁc factors

that could cause the aggregate demand curve to shift.

AGGREGATE DEMAND CURVE SHIFTERS

Anything that changes the amount of total spending

in the economy (holding price levels constant) will

affect the aggregate demand curve. An increase in any

component of GDP ( C , I , G , or X

M ) will cause the

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