Aggregate Demand

Macro Economics E202

Things to keep in mind!

In order to measure the aggregate quantity of Gs & Ss and the average price level, Real GNP (GNP valued at constant price) & GNP Deflator (Average price level measured by GNP deflator) are used respectively.

Definition

The aggregate quantity of Gs & Ss demanded is the sum of the quantities f goods and services demanded by households, of investment goods demanded by firms, of Gs & Ss demanded by govt., and of net exports demanded by foreigners. Therefore AD depends on decisions made by households, firms, governments and foreigners.
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AD Schedule & curve AD schedule lists the Q of real GNP demanded at each GNP deflator, holding all other influences on buying plans constant.

AD curve plots the Q of real GNP demanded against the GNP deflator.

The effect of a change in price level and any of other influences

Movement along the AD curve Shift in AD curve

Why the AD curve slopes downward?

There are three types of substitutes for the Gs & Ss that make up real GNP: 1. Money and Financial assets 2. Goods and services in the future and 3. Goods and services produced in other countries.

Money and the Real Balance Effect Real balance effect is the influence of a change in the Q of real money on the Q of real GNP demanded. The Q of money includes the Q of: 1. Currency 2. bank deposit 3. deposit at other types of FIs and 4. thrift institutions held by HHs and Fs. Real money is the measure of money based on the Q of Gs that it will buy.

Proposition of Real Balance Effect

The higher the Q of real money , the larger is the Q of real GNP demanded.
Therefore, the higher the price level (here, the GNP deflator), the lower the Q of real money, the smaller is the Q of real GNP demanded.

Intertemporal Substitution Effect

Substitution of Gs now for Gs later or of Gs later for now. Interest rate, which has great influence on it, is influenced by the Q of real money. (e.g. Low interest rate encourages people to borrow and spend on K goods and consumer durables.) If P lowers, - increase the Q of real money - increase lending - decrease borrowing - lowers interest rate - increase the AD

International Substitution Effect

3rd reason why AD curve slopes downward. Substitution of domestic Gs for foreign Gs or of foreign Gs for domestic Gs.

Lower domestic price encourages people to buy more domestically produced goods instead of goods produced at ROW.

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Changes in AD : AD increases if
Interest rate decreases Expected inflation rate increases Foreign exchange rate falls Expected future profit increases Q of money increases Aggregate wealth increases Govt. Spending increases Taxes decreases Transfers increases Foreign income increases Population increases

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