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ECO102H1 Lecture Notes - Aggregate Demand, Autonomous Consumption, Price Level

Course Code
James Pesando

of 5
AE Schedule:Price level is fixed
Price level does vary
Introduce: Aggregate Demand (AD) curve
AD = C + I + G + (X-M)
Price level (P) increases AD decreases
Motivation (introductory)
1. P increases Wealth decreases C decreases Household
holdings of Money (cash, bank deposits) decline in real terms as
price level rises, making households less wealthy.
2. P increases X decreases M increases For given
exchange rate, X become more expensive to foreign buyers and M
become less expensive for domestic buyers.
ExampleP1>P0 =>
C=100 + 0.9YD C=75 + 0.9YD
X=20 X=18
M = 25 M= 28
Household Wealth and Consumption
1.Wealth (as well as disposable income) influences consumption
2.Household has $10,000 in cash
3.Price level increases by 10%
4.Purchasing power of $10,000 cash declines to $9,000
5.Household reduces consumption (change in autonomous consumption)
Deriving the AD curve
1.AE schedule (drawn for a fixed price level)
2.AE schedule shifts down as price level increases.
P0: C0 + I + G + X0 M0 = Y0
P1>P0: C1 + I + G + X1 M1 = Y1
C1 < C0X1<X0M1>M0
Y1 Y0 = multiplier *(C(decrease) + X(decrease)
ThusP1 > P0 Y1 < Y0
Diagram #1 feb 14th, 2011
Diagram #2 feb 14th, 2011
Shifts in AD curve
Example: I = 10
Multiplier = 2
Y1 Y0 = shift in AD curve
=2 * 10
Aggregate Supply (AS)
1.AS: relation between real GDP (firms’ desired production) and price
level when prices of factors of production (including wages) are
2.Price level (P) UP = AS UP
Intuition: P increase higher profits(since wages and prices of other facotrs
of production do not change) firms desired production increases
AS: Intuition
1.Firm manufactures shirts
2.Signs contracts which
-fix wages for one year
- fix price of cloth for one year
3.If price level rises, firms profits increase, since
-price of shirts increases
-price of factors of production unchaged
4.Firm responds by increasing production.
AS diagram #5 feb. 14th, 2011.
Short-run Macroeconomic equilibrium, AD = AS
Refer to diagrm #6 from feb 14th, 2011.
At P1
1. firms’ desired output is Y1
2.Total desired spending [AD] exceeds Y1
Economic Adjustment
1.firms’ inventories are being (involuntarily) drawn down
2. Firms respond by increasing output and prices [Note: when
prices are assumed to be fixed, firms respond by increasing output
P1 increases to P0
Y1 increases to Y0
At P = P0: AD = AS Aggregate desired spending = firms desired output.
Recession in the United States
Autonomous Consumption drops, therefore savings increase
Personal savings rate (1-C/YD)
2007 0%
2008 (Jan-Nov)1.7%
2008 (Dec)3.6%
Imports to U.S. will fall Exports from canada fall
U.S. economy slows down:What happens to real GDP in Canada?
Insight: Demand for Canadas exports will fall. Diagram #1, Feb 16th,
AD AS Model
Exports: +10 Million
Multiplier = 2.5
Will Y increase by 25 million?
Result: AD shifts by 25 million
Y increases by less than 25 million since price level increases and lowers AD.
Diagram #2#3, feb 16, 2011.