Aggregate Demand/Supply Sample 1Real Balances

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One reason why aggregate demand slopes downward and to the right is the Real Balances Effect. When the price level declines, your savings becomes worth more and your buying power is boosted. For the macro economy, the real balances effect can be illustrated as shown. To interpret, suppose that Harriet has $5,000 in cash, and $10,000 in non monetary assets (car, computer, and Android). What is the value of her real balances when the price level is 120? Simply add her assets together, $15,000, and divide by the price level and multiply by 100. The value of her assets when the price level is 120 is $12,500. The value of her real balances when the price level is 100 is $15,000. As the price level falls, Harriets buying power increases causing her quantity demanded to increase from Q1 to Q2. When the price level increases, her buying power decreases and the quantity demanded falls. Notice that this is a movement along the curve since the only variable that is changing is the price level. AD1 (0) Assume that Harriet has $15,000 in cash and assets. Compute Harriets real balances for each price level in the table below. Price Level Real Balance 80 90 100 110 AD2(0) Suppose the price level changes from 123 to 125. What is the inflation rate? _________ Sample 2 Interest Rate Effect What is not spent is saved. So when the price level falls, the consumer buys a fixed market basket and save the rest. The supply of savings increases and interest rates fall. The lower interest rates induce more business investment and household consumption of durable goods. The quantity demanded of real GDP increases.

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Suppose that when the price level is 120 the interest rate is 8% . This means that for every $100 dollars a consumer or business borrows, they will pay back $8. If HNI borrows $10 million to finance capital restructuring, they will pay in interest $800,000. If the price level drops to 100 and consumers save more, HNI will only pay $600,000 in interest. This interest rate effect also works in reverse. AD3 (0) How much interest would HNI have to repay if they wanted to borrow $10 million and the interest rate was 4%? _____________ Sample 3 Foreign Purchases Effect When the price level is higher in Alpha than the price level in Beta, its cheaper for Alpha consumers to buy from Beta. Its like buying at Walmart* a pair of shoes for $10 instead of buying the shoes at Shoe Carnival for $20. So Alpha citizens buy less domestic goods and the quantity demanded decreases. In the example, the price level for Alpha increases from A to B. Alpha and Beta consumers find it cheaper to buy from Beta so the quantity demanded falls from Q3 to Q2.

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AD4 (0) Explain how the foreign purchases effect would work if the price level in Alpha decreased.

Sample 4 Aggregate Demand Shifts When the price level changes, the economy moves along the aggregate demand curve for three reasons. In other words, the quantity of aggregate demand changes as the price level changes. But the AD curve can shift because of exogenous variables. Anything that changes spending shifts the AD curve. So any change in C, I, G, or Nx shifts the curve. A change in personal taxes and expectations of future prices will shift the curve. When people feel wealthier, they spend more. So if the value of their assets or their income changes, AD shifts. One example will explain. Suppose the economy is at point B. If consumers spend more, business increase their investment, or the government increases its spending, the AD will shift to the right to point D. The same shift would have happened if personal income taxes were reduced, consumers felt that prices were going to be higher in the future, or stock market assets were increasing. If the USD were depreciating, the AD would shift from AD to AD1.

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AD5 (0) Event PL (U or D) Personal income taxes decrease Consumer confidence spurs increased spending Housing values skyrockets Businesses become pessimistic about the future The USD rapidly appreciates because of higher domestic interest rates Government slashes military spending iPods become the rage around the world. Domestic exports increase The money supply increases along with consumption The government pursues contractionary Fiscal Policy A lower reserve ratio spurs more lending to business. Investment increases U. S. goods suddenly become attractive to foreigners Businesses become optimistic about future sales Foreign income increases Business taxes increases. Businesses expect lower profits Consumer spending on durables declines USD appreciates relative to foreign currencies Personal income taxes decline Wealth increases because of higher stock market values AD (U or D) Real GDP (U or D)

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18.

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Solutions AD1 Price Level 80 90 100 110 AD2 The inflation rate is 1.62% AD3 The interest is: $400,000 AD4 The USD would appreciate as more US goods would be demanded by foreigners. Net exports would increase. AD would shift to the right. Event 1. Personal income taxes decrease 2. Consumer confidence spurs increased spending 3. Housing values skyrockets 4. Businesses become pessimistic about the future 5. The USD rapidly appreciates because of higher domestic interest rates 6. Government slashes military spending 7. iPods become the rage around the world. Domestic exports increase 8. The money supply increases along with consumption 9. The government pursues contractionary Fiscal Policy 10. A lower reserve ratio spurs more lending to business. Investment increases 11. U. S. goods suddenly become attractive to foreigners PL (U or D) Up Up Up AD (U or D) Real GDP (U or D) U Right Up U Right Up U Right Up Real Balance 18750 16666.67 15000 13636.37

Up Down Up Up Down Up Up

U Right D Left U Right U Right D Left U Right U Right

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12. Businesses become optimistic about future sales 13. Foreign income increases 14. Business taxes increases. Businesses expect lower profits 15. Consumer spending on durables declines 16. USD appreciates relative to foreign currencies 17. Personal income taxes decline 18. Wealth increases because of higher stock market values

Up Up Down Down Up Up Up

U Right U Right D Left D Left U Right U Right U Right

Up Up Down Down Up Up Up

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