CH 8

Chapter 8
AGGREGATE
DEMAND
Ifeanyi Uzoka, Sheridan College

Copyright © 2020 Nelson Education Ltd.
Chapter 8 Preview
8.1 The Determinants of Aggregate Demand
8.2 The Investment and Saving Market
8.3 The Aggregate Demand Curve
8.4 Shifts in the Aggregate Demand Curve
Copyright © 2020 Nelson Education Ltd. 2

 This section will answer the following key questions:
◦ What is aggregate demand?
◦ What is consumption?
◦ What is investment?
◦ What are government purchases?
◦ What are net exports?

 What is aggregate demand?
◦ Aggregate demand (AD) is the total demand for all final
goods and services in the economy.
◦ There are four components of AD:
 consumption (C), investment (I), government purchases (G),
and net exports (X – M).
AD = C + I + G + (X – M)

 What is consumption?
◦ Consumption (C) accounts for almost 60% of total
economic activity and is determined by:
 After-tax or disposable income
 Real interest rates (negatively related to consumption)
◦ The higher a nation’s income, the more it spends on
consumer items.

 What is consumption? [cont’d]
◦ Average propensity to consume (APC):
 The fraction of total disposable income that households
spend on consumption.
𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛
𝐴𝑃𝐶 =
𝐷𝑖𝑠𝑝𝑜𝑠𝑎𝑏𝑙𝑒 𝐼𝑛𝑐𝑜𝑚𝑒

 What is consumption? [cont’d]
◦ Marginal propensity to consume (MPC):
◦ The additional consumption resulting from an additional
dollar of disposable income.
 Consumption
𝑀𝑃𝐶 =
 Disposable Income

 Average Propensity to Consume (APC): A Numerical
Example
◦ If a consumer spends $450 out a disposable income of
$500, then:
𝑪𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏 𝟒𝟓𝟎 𝟗
𝑨𝑷𝑪 = 𝑫𝒊𝒔𝒑𝒐𝒔𝒂𝒃𝒍𝒆 𝑰𝒏𝒄𝒐𝒎𝒆
=
𝟓𝟎𝟎
=
𝟏𝟎
= 𝟎. 𝟗

 Marginal Propensity to Consume (MPC): A Numerical
Example
◦ If a consumer increases spending from $450 to $600 when
Disposable income rises from $500 to $700, then:
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑪𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏 𝟏𝟓𝟎 𝟑

𝑴𝑷𝑪 = = = = 𝟎. 𝟕𝟓
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑫𝒊𝒔𝒑𝒐𝒔𝒂𝒃𝒍𝒆 𝑰𝒏𝒄𝒐𝒎𝒆 𝟐𝟎𝟎 𝟒

 What is investment?
◦ Investment (I) is approximately 20% of GDP.
◦ Highly unstable, subject to economic, social, and political
variables.
◦ Good business conditions “induce” firms to invest.

 What is investment?
[cont’d]
o If firms expect higher sales
and profits, they will
increase investment
spending on capital goods,
such as factories,
machinery, and equipment.

 What are government purchases?
◦ Government purchases (G) are purchases by federal,
provincial/territorial, and local governments of new goods
and services produced.
◦ Government purchases include expenditures on healthcare,
education, highways, and police protection.
◦ In 2017, government purchases accounted for 25 percent of
total spending.

 What are net exports?
◦ Open economy: Economic model that includes the effects
of international trade and finance on aggregate demand.
◦ Exports: Canadian-made goods and services sold to foreign
customers.
◦ Imports: Goods and services bought from foreign suppliers.

 What are net exports? [cont’d]
◦ Net exports: The difference between the value of exports
and the value of imports.
◦ Trade surplus: Positive net exports (exports > imports);
increases aggregate demand.
◦ Trade deficit: Negative net exports (exports < imports);
decreases aggregate demand.

 Section Check
◦ Aggregate demand is the sum of the demand for all final
goods and services in the economy.
◦ Consumption (the purchases of consumer goods and services
by households) is the largest component of aggregate
demand.

 Section Check [cont’d]
◦ Empirical evidence suggests that consumption increases
directly with any increase in income.
◦ Investment spending refers to the purchases of investment
goods, such as machinery and equipment.
◦ Changes in investment spending are often responsible for
changes in the level of economic activity.

◦ Government purchases are made up of federal, provincial,
territorial, and municipal purchases of goods and services.
◦ Net exports are the difference between the value of exports
and the value of imports.
◦ Trade deficits lower aggregate demand, other things being
equal; trade surpluses increase aggregate demand, other
things being equal.

◦ What is the investment demand curve?
◦ What is the saving supply curve?
◦ How is equilibrium determined in the investment and
saving market?
◦ What effect do budget surpluses and budget deficits have
on the investment and saving market?

 Exhibit 1: Volatility of Investment, 1981–2017

 What is the investment demand curve?
◦ The investment demand (ID) curve shows the dollar
amount of investment at different real interest rates.
◦ It is downward sloping.
◦ It reflects the fact that investment spending varies
inversely with the real interest rate.

 What is the investment demand curve? [cont’d]
◦ At high rates of real interest, firms will only pursue
investments with even higher expected rates of return.
 This will cause the quantity of investment to fall.
◦ As real interest rates fall, projects with lower rates of
return become profitable.
 This will cause the quantity of investment to rise.

Exhibit 2:The Investment Demand Curve
o There is an inverse
relationship between
the real interest rate
and the quantity of
investment demanded.

◦ The investment demand curve will shift as a result of changes
in technology, inventories, expectations and/or business
taxes.
◦ If firms expect higher rates of return on investment then, for
a given interest rate, the ID curve will shift to the right.
◦ If firms expect lower rates of return on investment then, for a
given interest rate, the ID curve will shift to the left.

 Exhibit 3: Shifts in the Investment Demand Curve
o Any change in technology,
inventories, expectations,
and business taxes can
cause the investment
demand curve to shift.

◦ Technology: Product improvements or lower costs of
production will increase the rate of return and cause the
ID curve to shift to the right.
◦ Inventories: Excess inventories will discourage further
investment, while depleted inventories encourage
investment.

◦ Expectations: If firms expect higher sales and profits, they
will invest more in plants and equipment now, shifting ID
curve to the right.
◦ Business taxes: Lower taxes increase potential after-tax

profits on investment projects and shift the ID curve to
the right.

 What is the saving supply curve?
◦ The supply curve of savings is upward sloping.
◦ At a lower real interest rate, a lower quantity of savings
is supplied.
◦ National Saving is saving from the public and private
sectors.
S = (GDP – C – T ) + (T – G )

 What is the saving supply curve? [cont’d]
◦ Private saving is the amount of income that households
have left over after consumption and taxes.
Sprivate =GDP – C –T
◦ Public saving is the amount of income the government

has left over after paying for its spending.
S =T–Gpublic

 Exhibit 4: Savings Supply Curve
o There is a positive
relationship between
the real interest rate
and the quantity of
saving supplied.

 What is the saving supply curve? [cont’d]
◦ Two non-interest rate determinants of the saving supply
curve act as saving supply curve shifters:
 Disposable income: Lower taxes mean higher disposable
income, increasing savings at each interest rate.
 Earnings expectations: Lower expected future earnings
lead to more saving now at any given interest rate.

 Exhibit 5: Shifts in the Saving Supply Curve
o Any change in the
determinants of saving
supply other than interest
rates—such as disposable
(after-tax) income or
expected future earnings—
can cause the saving supply
curve to shift.

 How is equilibrium determined in the investment
and saving market?
◦ Equilibrium:
 Desired investment equals desired national saving.
 Occurs at the intersection of the investment demand
curve and the saving supply curve.

 Exhibit 6: Equilibrium in the Saving and Investment Market
o Equilibrium in the saving
and investment market
occurs at the intersection
of the investment demand
curve and the saving
supply curve.

 How is equilibrium determined in the investment and
saving market? [cont’d]
◦ If the real interest rate is above the equilibrium real
interest rate:
◦ The quantity of saving supplied will be greater than the
quantity of investment demanded.
◦ Lenders will compete to attract borrowers.
◦ Real interest rate falls.

 What effect do budget surpluses and budget deficits
have on the investment and saving market?
◦ Budget Surplus: Government receives more in tax
revenues than it spends (T > G).
 Public saving increases.
 National saving increases, shifting the saving supply curve
to the right.

have on the investment and saving market? [cont’d]
◦ Budget surplus leads to:
 a decrease in the real interest rate
 an increase in equilibrium saving and investment

Exhibit 7: Effects of a Government Budget Surplus
◦ When the government runs
a budget surplus, public
saving is positive.
◦ Increases national saving
and shifts the saving
supply curve rightward
from SS0 to SS1.

 What effect do budget surpluses and budget deficits have
on the investment and saving market? [cont’d]
◦ Budget Deficit: Government spends more than it receives
in tax revenues (G > T).
◦ Public saving decreases (dissaving).
◦ National saving decreases, shifting the saving supply curve
to the left.

have on the investment and saving market? cont’d
◦ Budget deficit leads to:
 Increases in the real interest rate.
 Decreases in equilibrium saving and investment.
 Crowding-out effect: When the real interest rate rises
because of a government budget deficit, private
investment decreases.

Exhibit 8: Effects of a Government Budget Deficit
◦ When the government

runs a budget deficit,
public saving will be
negative and national
saving decreases.

 Section Check
◦ The investment demand curve is downward sloping,
reflecting the fact that the quantity of investment demanded
varies inversely with the real interest rate.
◦ Technology, inventories, expectations, and business taxes

can shift the investment demand curve at a given real
interest rate.

◦ The supply of national saving is composed of both private
saving and public saving.
◦ The supply curve of saving is upward sloping, reflecting the
fact that the quantity of savings is positively related to the
real interest rate.
◦ Two non-interest determinants of the saving supply curve are
disposable (after-tax) income and expected future earnings.

◦ In equilibrium, desired investment equals desired national
saving at the intersection of the investment demand curve
and the saving supply curve.
◦ A surplus of saving will occur at real interest rates above
equilibrium, and shortages of saving will occur at real
interest rates below equilibrium.

◦ Budget surpluses lead to increases in national saving,
lower real interest rates, and increases in the quantity of
saving and investment.
◦ Budget deficits reduce national saving, increase the real
interest rate, and lower the quantity of saving and
investment.

◦ How is the quantity of real GDP demanded affected by
the price level?
◦ Why is the aggregate demand curve negatively sloped?

 How is the quantity of RGDP demanded affected by the
price level?
◦ The aggregate demand curve is a graph that shows the
inverse relationship between the price level and RGDP
demanded.
◦ Three reasons for inverse relationship:
1. Real wealth effect,
2. Interest rate effect, and
3. Open economy effect.

Exhibit 1: The Aggregate Demand Curve
◦ The aggregate demand
curve slopes downward,
reflecting an inverse
relationship between the
overall price level and the
quantity of RGDP demanded.

 Why is the aggregate demand curve negatively sloped?
◦ The real wealth effect and changes in consumer spending:
 An increase in the price level reduces real wealth.
 Decreases in planned purchases lowers the quantity of
RGDP demanded.
◦ Reverse is also true: A decrease in price level increases the
quantity of RGDP demanded.

Price level  Real wealth  Purchasing power
 RGDP demanded
The reverse is also true!
Price level  Real wealth  Purchasing power

RGDP demanded

Interest rate effect: A change in investment.
◦ If the price level increases, more money is demanded
for purchases.
◦ Greater demand for money will increase interest rates.
◦ Higher interest rates will cause decreases in
 investment spending,
 purchases of durable goods, and
 real GDP demanded.

Price level  Interest rate  Investment

And the reverse is also true.
Price level  Interest rate  Investment

 RGDP demanded

Open Economy Effect: Changes in net exports.
◦ If prices in the domestic market rise relative to global
markets, consumers buy more from foreign producers and
less from domestic producers.
◦ Since real GDP is a measure of domestic output, the
reduction in purchases from domestic producers leads to a
lower RGDP demanded.

Open Economy Effect: Changes in Net Exports
Price level  Demand for domestic goods

And the reverse is true.
Price level  Demand for domestic goods

 RGDP demanded

 Section Check
◦ An aggregate demand curve shows the inverse relationship
between the amounts of real goods and services (RGDP)
that are demanded at each possible price level.
◦ The aggregate demand curve is downward sloping because
of the real wealth effect, the interest rate effect, and the
open economy effect.

◦ What variables cause the aggregate demand curve to shift?
◦ Can we review the determinants that change aggregate
demand?

 What variables cause the aggregate demand curve to
shift?
◦ A change in the price level causes a movement along the
aggregate demand (AD) curve.
◦ If a nonprice-level factor causes total spending to increase,
then the AD curve will shift to the right.
◦ If a nonprice-level factor causes total spending to decrease,
then the AD curve will shift to the left.

Exhibit 1: Shifts in the Aggregate Demand Curve
• An increase in aggregate
demand shifts the curve to
the right (from AD to AD ).
0 1
• A decrease in aggregate
demand shifts the curve to
the left (from AD to AD ).
0 2

shift? [cont’d]
◦ Changing consumption may be due to a variety of factors:
• Change in consumer confidence
• Change in wealth
• Change in population
• Tax cuts or increases

shift? [cont’d]
◦ Changing investment is also influenced by several factors:
 Business confidence
 Real interest rates
 Tax cuts or increases
◦ Changing government purchases are influenced by
government spending and taxation.

shift? [cont’d]
◦ Changing net exports may be influenced by:
• Economic conditions in other countries.
• Exchange rates (international price of currency).

 Exhibit 2: Possible Aggregate Demand Shifters

 Exhibit 2: Possible Aggregate Demand Shifters.

Exhibit 2: Possible Aggregate Demand Shifters

 Section Check
◦ A change in the price level causes a movement along the
aggregate demand curve, not a shift in the aggregate
demand curve.
◦ Aggregate demand is made up of total spending:
C + I + G + (X – M).
◦ Any change in these factors will cause the aggregate
demand curve to shift.


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Chapter 8

Ifeanyi Uzoka, Sheridan College

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𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑪𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏 𝟏𝟓𝟎 𝟑

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◦ Business taxes: Lower taxes increase potential after-tax

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◦ Public saving is the amount of income the government

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◦ When the government

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◦ Technology, inventories, expectations, and business taxes

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◦ Why is the aggregate demand curve negatively sloped?

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Price level  Real wealth  Purchasing power

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Price level  Interest rate  Investment

Price level  Interest rate  Investment

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Price level  Demand for domestic goods