Aggregate Demand

Aggregate demand The total quantity of real GDP demanded is the total expenditure of consumers, businesses, government and foreigners on final goods and services produced in the U.S. Y = C + I + G + NX All other things remaining constant, the higher the price level, the smaller is the quantity of real GDP demanded; the lower the price level, the greater is the quantity of real GDP demanded. As we move along the AD curve, the only thing that can cause a change in the quantity of real GDP demanded is a change in the price level. Why does the AD curve slope downward? The higher the price level, the lower the purchasing power of a given nominal amount of money. Therefore consumers and firms reduce their expenditures. The quantity of real GDP demanded decreases. Also, the higher the price level in the U.S., holding prices in other countries constant, the lower is spending by foreigners and U.S. residents on U.S.produced goods and the higher is spending on foreign-produced goods. Net exports from the U.S. decrease. Therefore the quantity of domestically produced real GDP demanded decreases. The lower the price level, the greater the purchasing power of money, and therefore expenditure increases. Also, lower domestic prices relative to foreign prices cause net export expenditure to increase. For both of these reasons, the quantity of real GDP demanded increases. Shifts of the AD curve A shift of the AD curve is called a change in aggregate demand. A change in any factor, other than the price level, that affects expenditure plans causes a shift in AD. Shifts in AD can be either increases or decreases in AD. An increase in AD means an increase in the quantity of real GDP demanded at each price level. The AD curve shifts to the right. A decrease in AD means a decrease in the quantity of real GDP demanded at each price level. The AD curve shifts to the left: The main factors causing shifts of AD are: Expectations Fiscal and monetary policy Changes in the world economy Expectations: An increase in expected future income increases current consumption expenditure at any given level of prices. AD increases. An increase in expected future inflation causes an increase in current consumption expenditure at any given level of current prices, as households purchase more goods and services in anticipation of their prices rising in the future. AD increases. An increase in expected future profit causes firms to increase current investment expenditure at any given level of prices. AD increases. Fiscal and monetary policy: An increase in government expenditure or a cut in net taxes causes an increase in total expenditure at any given level of prices. AD increases. A cut in interest rates or an increase in the money supply causes an increase in expenditure at any given level of prices. AD increases. The world economy: If the U.S. dollar rises in value relative to foreign currencies, foreign-produced goods become relatively cheaper than U.S.-produced goods. Expenditure on U.S.-produced goods (by both foreigners and U.S. residents) decreases, and AD in the U.S. therefore decreases. An increase in income in foreign countries causes an increase in foreigners’ expenditure, including their expenditure on U.S. exports, and therefore an increase in AD in the U.S. The AD multiplier When AD increases, the increase in expenditure causes an increase in income. This increase in income causes a further round of increased consumption expenditure, and therefore a further increase in AD. For example, suppose there is initially an increase in investment expenditure, ΔI: The initial AD curve shifts out from AD0 to AD0+ΔI. The extra investment spending causes an increase in income which causes a further round of consumption increases, etc., and AD increases further to AD1. AD1 now describes aggregate spending plans at each price level.