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Chapter 9: Aggregate Demand

Key wo rd s : P l a n n e d & A c t u a l I nve st m e nt


Planned investment (Ip) is the amount of investment firms plan to
undertake during a year = Total business expenditures on plants and
equipments + planned production of inventories (goods that firms
are planning to keep as inventories for the future).
Actual investment (I) is the amount of investment actually
undertaken during a year = planned investment + unplanned changes
in inventories = (Ip) + unplanned changes in inventories .
(I) (Ip) = unplanned changes in inventories can be either positive
(unintended inventory accumulation: actual inventories > planned
inventories there was a lack of demand) or negative (unintended
inventory decumulation: actual inventories < planned inventories
there was an excess of demand you had to sell goods that you had
been planning to keep as inventories for the future).

Aggregate Demand (AD)- Definition


In macroeconomics, the focus is on the demand and supply of all goods and
services produced by an economy. Accordingly, the demand for all individual
goods and services is combined and referred to as aggregate demand. AD is
the total amount of goods and services demanded in the economy at a given
overall price level and in a given time period. AD correspond to the total value
of REAL GDP that all sectors of the economy are willing to purchase at a given
overall price level and in a given time period.

Aggregate Demand (con)

AD = C + Iplanned + G + (EX IM)


Recall: GDP (Y), by the expenditure
approach is:
Y = C + I + G + (EX IM)

Aggregate Demand(con)
If firms produce goods that NEITHER THE FIRM

NOR

THE

CUSTOMERS WERE DEMANDING, those goods are counted


in GDP, as unintended inventory accumulation, but they are
not part of aggregate demand, because, clearly, NOBODY
desired them.

The difference between AD and GDP = unintended


inventory accumulation.

Aggregate Demand - Components


Aggregate demand is composed of the sum of aggregate expenditures:

AD = Expenditures = C + Iplanned + G +(X - M)


Where:
C = Consumers' expenditures on goods and services.
Iplanned = The amount of investment firms plan to undertake during a year.

G = Governments expenditures on publicly provided goods and services.


X = Exports of goods and services.
M = Imports of goods and services.

Aggregate Demand Curve


Aggregate demand is represented
by

the

aggregate-demand

curve, which represents the


quantity of goods and services
that

will

be

demanded

(purchased) at different price

levels. This is the demand for


the gross domestic product

(GDP) at different price levels.

Three Reasons why the AD Curve Slopes Down


1) The Real Balance Effect
A higher aggregate price level (higher inflation) reduces the
purchasing power of households and companies wealth they
will feel poorer their spending will .

2) The Interest Rate Effect


A higher aggregate price level (higher inflation) Nominal
interest rate (nominal interest rate = real interest rate + inflation
rate ) savings spending .

3) The Foreign Purchases Effect


If prices rise in the homeland, exports decrease and imports
increase, so Xnet decreases.

When a change in the price level


causes equilibrium GDP to change,
we move along the AD curve.
Whenever anything other than the
price level causes equilibrium GDP to
change, the AD curve itself shifts.

Shift Factors of the AD Curve


Shifts in the aggregate demand curve are not caused by changes in
the price level. Instead, they might be caused by ANY changes:
1)
2)
3)
4)
5)
6)

In the demand for consumption goods and services (C).


In investment spending (I).
In the government's demand for goods and services (G).
In the demand for net exports (EX IM).
In fiscal policy [ Tax and/or government spending AD].
In monetary policy [Federal Reserve money supply
interest rates spending AD].
7) In consumer confidence or expectations.
8) In consumer wealth.
9) In the stock of physical capital (factors of production, such as
machinery, buildings, or computers..).

Shifts of the AD Curve (com)


In general, any expansionary policy
shifts the aggregate demand curve to
the right while any contractionary
policy shifts the aggregate demand
curve to the left.
A shift to the right of the aggregate
demand curve. from AD to AD, means
that at the same price levels the
quantity demanded of real GDP
has increased.
A shift to the left of the aggregate
demand curve, from AD to AD, means
that at the same price levels the
quantity demanded of real GDP
has decreased.

Aggregate Supply (AS)


Aggregate Supply is the total supply of goods and services that firms in
a national economy plan on selling during a specific time period. It is

the total amount of goods and services that firms are willing to sell at
a given price level in an economy. Aggregate supply is represented

by the aggregate- supply curve, which represents the quantity of


real GDP that is supplied by the economy at different price levels.

The Short Run Aggregate Supply Curve


Classical economists believe that in the

short run the aggregate supply curve is


upward sloping. In the short run an

increase in aggregate demand may lead


to an increase in output, but there will

also be an increase in the price level.

The Long Run Aggregate Supply Curve


Classical economists believe that in the long run the
level of real production (GDP) is maintained
regardless of the price level, which creates a vertical,
or perfectly elastic, aggregate supply curve. This
relation results due to flexible prices, which ensure
that resources markets maintain equilibrium balance
at full employment (which corresponds to the natural
unemployment rate) . Should the price level rise or fall,

wages and resource prices adjust to ensure that


quantity demanded equals quantity supplied in
resource markets.

The Keynesian Aggregate Supply Curve


John Maynard Keynes argued that prices and wages were

sticky, in particular they were inflexible downward due to the


existence of unions and contracts between employers and

employees. He argued that in a world of excess capacity, an increase


in aggregate demand will not impact prices (as the classical
economists thought) but will instead impact real GDP.
The assumptions of the Keynesian model are the same as the
classical model except for two important differences: prices and

wages are sticky, and excess capacity exists in the economy.

The Keynesian Aggregate Supply Curve (con)


Within the Keynesian framework,
the aggregate supply (AS) curve
is sketched horizontally. This is
done because prices are sticky
in the short run, represented by
the

flat

change).

line

(prices

dont

Because this only

occurs in the very short run, we


label

this

the

short

run

aggregate supply curve (SRAS1).

The Keynesian Aggregate Supply Curve (con)


New Keynesians realized that
prices and wages were not
perfectly sticky, even in the
short run. Because of this
they developed a new SRAS
curve which was upward
sloping. This allowed for
some price and wage
stickiness, but also allowed
for some flexibility.
This
upward sloping SRAS2 supply
curve has become the
standard SRAS curve used in
economic analysis.

The Keynesian Aggregate Supply Curve (con)


We may also see charts that
show two SRAS curves, one
horizontal, and one upward
sloping.
Generally the
horizontal curve shows the
very short run, and the upward
sloping shows the short to
medium run aggregate supply
curve. In the long run, we end
up back with the classical
model (LRAS), so the three
different aggregate supply
curves show us how prices and
real GDP will change over
short, medium, and long time
frames.

The ADAS Model


The ADAS or aggregate demand
aggregate supply model is a
macroeconomic

model

that

explains price level and output


(GDP) through the relationship of
aggregate demand and aggregate
supply. It is based on the theory of

John Maynard Keynes presented in


his work The General Theory of
Employment, Interest, and Money.