Aggregate Demand

Dr. Rilina Basu (Banerjee)

For undergraduate Introductory Macroeconomics course
Department of Economics
Jadavpur University
Some facts about Economic Fluctuations
+Economic fluctuations are irregular and unpredictable
+Most macroeconomic quantities fluctuate together
+As output falls, unemployment rises

Okun’s Law (1962): Y = Y − c(u − u )

Y: actual output, Y: Potential output, u : natural rate of unemployment

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Explaining short run fluctuations
+ Classical Dichotomy + In the short run, real and
+ Neutrality of Money nominal variables are
intertwined
+ Money is no longer
+ Money is a veil
neutral

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The AD-AS model
Here we focus on the behaviour of two variables:
a) economy’s output of goods and services i.e. real GDP
b) Average level of prices i.e. CPI or GDP deflator
While output is a real variable, price is nominal

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AD: quantity of goods and services that households,
firms, Government and customers from the rest of the
world want to buy at each price level
AS: quantity of goods and services that firms produce
and sell at each price level
The price level and the quantity of output adjust to
bring aggregate demand and aggregate supply into
balance.

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+ This is different from micro model of demand and supply in the
sense that microeconomic substitution from one market to another
is impossible for the economy as a whole.
+ AD-AS model help in explaining short run fluctuations in economic
activity around its long run trend.

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Aggregate Demand Curve
Y = C + I + G + NX
C, I, G, NX gives the aggregate demand for goods and
services
G = G is exogenous or fixed by policy
C, I and NX depend on economic conditions in
particular on the price level.

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Consumption and Price Level: Wealth Effect

+ Consumers hold money in wallet or banks

+ Nominal value of money is fixed, but real is not
+ P ↓⇒Value of Money(M/P) ↑⇒ C ↑⇒ demand for
goods ↑
+ So inverse relationship between C and P
C = C(M/P), c’>0 Real balance effect
So AD schedule can be downward sloping from
consumption demand.
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Price level and Investment: Interest Rate Effect
+ When price level is lower, households need less money
to buy goods and services
+ P↓ ⇒ Money holding by hhlds↓ ⇒ lending↑ (deposits
or may buy bonds) i.e. some money is converted to
interest bearing assets⇒ interest rate↓⇒ borrowing
cheaper⇒ Investment by firms↑
I = I(r), I’<0
Another logic behind downward slope of AD

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Price level and Net Exports: Exchange Rate Effect

Domestic Price↓⇒domestic interest rate↓⇒ capital

outflow⇒ exchange rate depreciates ⇒foreign
goods become more expensive relative to
domestic goods⇒M↓, X↑⇒ NX↑
Marshal Lerner Condition: x +m 1
Once again AD will be downward sloping

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Summing Up
If P falls,
+ Consumers are wealthier, Consumption dd rises
+ Interest rates fall and demand for investment increases
+ Currency depreciates and net exports demand increases
AD schedule is downward sloping “other things equal”

Changes in parameters will bring about shifts of the AD curve

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Shifts of the AD curve
When the quantity of goods and services demanded
at a given price level change, then the AD shifts.

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Changes in consumption

+ People start saving more

+ Stock market boom is there
+ Tax cut is introduced as a policy (Y-T)
When at a given price level C increases, AD shifts to
the right.

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Changes in Investment
+ New inventions which improve proficiency
+ Firms become pessimistic about future business
conditions
+ Investment Tax credit given
+ Money supply increases

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Changes in Government purchases
Since G is exogenous , any change in G brings about a
shift of the AD curve

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Changes in Net Exports

+ Foreign country faces recession

+ Speculation

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Thank You