ECN 204 Lecture Notes - Lecture 3: Longrun, Real Wages, Economic Equilibrium

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blushfrog753

28 Jun 2018

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Alexandra Karkaby

31/01/18 Week 3

Aggregate Demand and Aggregate Supply

Aggregate Demand

● Listings of the amount of output that would be demanded at every price level.

● The relationship between the real output demanded and price level is negative

→ AD curve is sloping downwards

Why is the Aggregate Demand Curve Sloping Downward?

1. Real Balances Effect

● A higher price level reduces the purchasing power of financial assets with fixed nominal

value, which will decrease the quantity of output demanded.

2. Interest-Rate Effect

● A higher price level increases the demand for money, which increases the interest rate;

higher interest rates will decrease the quantity of output demanded.

3. Foreign-Trade Effect

● A higher domestic price level will decrease the demand the quantity of real domestic

output demanded by foreigners, and increase the quantity of real foreign output

demande by domestics.

○ Ex. A higher Canadian price will decrease the quantity of real Canadian output

demanded by Americans, but will increase the quantity of real American output

demanded by Canadians.

Moving Along the Curve VS Movement of the Curve

● A change in price causes a movement along the AD curve.

● Changes in other factors causes a movement of the AD curve

Components of Aggregate Demand

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● AD represents demand for domestic goods/services from four sectors of the economy.

1. Household → demand goods/services for private consumption

2. Business → demand goods/services for private investment

3. Government → demand goods/services for public provision

4. Foreign → foreigners demand goods/services for export

** Sectors 1-3 also demand goods/services from abroad

○ Increase demand for goods from abroad = lower demand for domestic goods

● AD = C + I + G + (X - M)

Main Factors Affecting Aggregate Demand

1. Government Spending Decision

● A decision to increase government spending = increase demand from the government.

● These decisions (+taxation) compose the government’s fiscal policy.

2. Taxes

● Increased income taxes decreases disposable income (income after tax), leading to

less demand from households.

● Increased business taxes decrease the profitability of investment projects, leading to

less demand from business.

3. Exchange Rates

● An appreciation of the domestic currency makes it more expensive for foreigners to buy

domestic goods, leading to less demand from foreign countries.

● An appreciation of the domestic currency also makes it less expensive to buy goods

from abroad, which decreases demand from households, business, and government for

domestic goods.

4. Interest Rates

● Increase interest rate makes it more expensive to borrow, leading to less demand from

households and businesses.

● Increase interest rate also leads to an appreciation of domestic currency, leading to a

further decrease in AD.

5. Expectations About the Future

● Includes expectations about future interest rates, taxes, exchange rates, as well as a

change in the price level and the level of real output.

Foreign Exchange Rates

● The price of one currency in terms of another currency.

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Document Summary

Listings of the amount of output that would be demanded at every price level. The relationship between the real output demanded and price level is negative. Why is the aggregate demand curve sloping downward: real balances effect. A higher price level reduces the purchasing power of financial assets with fixed nominal value, which will decrease the quantity of output demanded: interest-rate effect. A higher price level increases the demand for money, which increases the interest rate; higher interest rates will decrease the quantity of output demanded: foreign-trade effect. A higher domestic price level will decrease the demand the quantity of real domestic output demanded by foreigners, and increase the quantity of real foreign output demande by domestics. A higher canadian price will decrease the quantity of real canadian output demanded by americans, but will increase the quantity of real american output demanded by canadians. Moving along the curve vs movement of the curve.

Related Questions

What is aggregate demand?

What is Aggregate Demand?

Aggregate Demand refers to the total expenditure on domestic goods and services within an economy. The Aggregate Demand (AD) thus represents the relationship between the total quantity of output demanded in the economy and the overall price level. Like the basic demand curve, the AD curve also slopes downward to reflect the inverse relationship between aggregate price and aggregate quantity demanded.

In response to a negative supply shock, the government decreases taxes. The most likely result of the government's tax decrease is:

	a decrease in unemployment and a decrease in the aggregate price level.
	a decrease in unemployment and an increase in the aggregate price level.
	an increase in unemployment and an increase in the aggregate price level.
	an increase in unemployment and a decrease in the aggregate price level.

If the aggregate price level rises, holding everything constant, consumers will:

	demand less aggregate output at all price levels resulting in a shift right of the AD curve.
	find their purchasing power has increased and will purchase more goods and services leading to an increase in the aggregate output demanded.
	need more money to purchase the same basket of goods which will lead to an increase in the demand for money leading to interest rate increases, and a reduction in the quantity of aggregate output demanded via a drop in investment demand.
	need less money to purchase the same basket of goods which will lead to a decrease in the demand for money leading to interest rate decreases, and an increase in the quantity of aggregate output demanded via an increase in investment demand.