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Dr. Mohammed Alwosabi

Dr. Mohammed Alwosabi

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Published by coldpassion
Econ 141, By Dr.Alwosabi
Econ 141, By Dr.Alwosabi

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Published by: coldpassion on Dec 07, 2009
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Dr. Mohammed Alwosabi Econ 141 - Ch.31
Notes on Chapter 3AGGREGATE DEMAND AND AGGREGATE SUPPLY
The AD-AS model determines RGDP and GDP Deflator and helps usunderstand the performance of three macroeconomic fundamentals:1. Growth of potential GDP2. Inflation3. Business cycle fluctuations (expansion and recession)
AGGREGATE DEMAND (AD)
AD is the total amount of goods and services produced in a country(i.e., the quantity of RGDP demanded) that people, businesses,government, and foreigners are willing and able to buy at differentprice levels within a given period.AD = RGDP = Y = C + I + G + NX
Aggregate Demand (AD) Curve
The aggregate demand curve (AD) shows theinverse relationship between RGDPdemanded and the price level (using eitherthe GDP Deflator or CPI) when all otherthings remain the same.
AD curve has negative slope (slopes downward) because of twoeffects:
RGDPPP
0
 
P
1
ADY
0
Y
1
 
0
 
Dr. Mohammed Alwosabi Econ 141 - Ch.32
 
Wealth Effect:
 
o
Real wealth is measured as the amount of goods and serviceswealth will buy.
o
When price level increases but other things remain the same,real wealth decreases. To restore their wealth, people increasesaving and decrease current consumption
RGDP demandeddecreases
o
Conversely, if the price level of goods and services fall but thevalue of your assets do not, you feel wealthier and may startconsuming more
RGDP demanded increases
o
Example:Suppose an individual holds BD50,000 in saving account. If theprice level in Bahrain rises by 6%, then the individual’s realwealth decreases is worth less in terms of what it can purchase.As a result, consumption expenditure decreases and savingincreases to restore the original wealth.
 
Substitution Effect:
1. Inter-temporal substitution effect (interest rate effect):
o
The substitution effect involves substituting goods in the futurefor goods in the present or goods in the present for goods in thefuture. This is called inter-temporal substitution effect (asubstitution across time).
o
This effect is mainly a result of changes in the real interest rate,which affect the decisions of households and businesses interms of their willingness and ability to borrow.
 
Dr. Mohammed Alwosabi Econ 141 - Ch.33
o
As the price level falls, causing demand for money to decreaseand interest rate to decrease, consumers may decide that it isnot worth it to save since they do not receive as much return.On the other hand, they may decide that since it is now cheaperto borrow, they will increase their borrowing to finance theirconsumption and investment, which would increase RGDPdemanded. The net effect of the decline of the interest rate isincreasing present consumption and decreasing saving
o
Alternatively, when price level increases and other thingsremain the same, demand for money increases
interest rateincreases
spending on consumption and investmentdecreases
RGDP demanded decreases. Saving increases toincrease future consumption2. International substitution effect:
o
When the domestic price level rises,
 
and other things remainthe same, domestically made goods and services become moreexpensive relative to foreign made goods and services. Thischange in relative prices encourage people to spend less in thedomestically made goods and more on foreign made products(export decreases and import increases
net exportdecreases)
o
Conversely, when the domestic price level falls,
 
and otherthings remain the same, domestically made goods and servicesbecome less expensive relative to foreign made goods andservices. This change in relative prices encourage people tospend more in the domestically made goods and less on foreignmade products (export increases and import decreases)

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