Derivation of AD curve and decomposition

of AD curve
Lecture 8
Sec D, E and PGP-FIN_03

RAC Chair RAC Area Member RAC Cross-Area Member

Prof. Sumit Mitra Prof. Anubha S. Sinha Prof. Debabrata Chatterjee
A complete model
o So far we have focused separately on three features of the economy:
o Output (GDP).
o Prices.
o Unemployment.
o These factors do not fluctuate independently.
o The model of aggregate demand and aggregate supply shows how output, prices,
and employment are all tied together as part of a single economic equilibrium.

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Aggregate demand

o The aggregate demand curve shows the relationship between the overall
price level and the total demand for all goods and services in the economy.
o What do you think happens to AE when the price level goes up?
o C: Real value of wealth falls, so C goes down
o I: Real value of liquidity in the economy falls, monetary conditions tighten,
interest rates go up, so I goes down
o G: does not change
o X-M: Foreigners reduce their spending on our costlier goods, we increase
spending on cheaper foreign goods, so (X-M) goes down
o Therefore, AE goes down when P goes up
• Say, initial price level =130
• The AE line identifies real GDP
demanded of $14.0 trillion: point e
• At the higher price level of 140, the
AE line shifts down to AE’, and real
GDP demanded falls to $13.5
trillion: point e’
• At the lower price level of 120, the
AE line shifts up to AE’’and real
GDP demanded increases to $14.5
trillion: point e’’
• Connecting e, e’, and e’’ yields the
downward-sloping AD curve.

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AD is downward sloping
Real balance effect: Real wealth
effect
More goods can be purchased
Foreign purchases and
international balance effect
Foreigners buy more good and NX increase
• Interest rate effect
Demand for money decreases causing interest
rate to fall.
Interest rate sensitive Investment will increase

27/06/2023 Board Capital and CSR 5

What happens to AD when spending goes up?
• A shift of the AE line at a given price
level shifts the AD curve.
• An increase in investment of 0.1
trillion, with the price level constant at
130, causes the PAE line to shift up.
• As a result, real GDP demanded
increases from 14.0 trillion to 14.5
trillion.

• Consequently, the aggregate demand

curve shifts from AD to AD’. At
prevailing price level of 130, real
GDP demanded increases by 0.5
trillion

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 Shifts in Aggregate demand: C’, I’,G’,NX’
Aggregate Demand curve can shift ( given the prices are kept constant)
 Higher expected income
Households can change their preferences and demand more at any given
price ( we studied the determinants of C, I, NX)
Firms can change their investment plans
Govt policy change (Fiscal policy, Monetary policy)
Net exports growth can increase/decrease due to international
factors( exchange rate, Global growth)
More output (real GDP demanded) at same price (CPI has remained same
in the three months of a quarter)
AD= C+I+G+NX
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As managers how do you know AD has increased, decreased or remained the same.

Which components of AD curve show big changes when there is a business cycle?
Are these changes
1. Pro-cyclical : Move at the same direction
2. Counter-cyclical : Moves at opposite direction
3. Acyclical : No clear movement
Are the timing of these changes follow
1) Leading : More in advance of aggregate economy
2) Coincident : More at the same time
3) Lagging: Move with a lag or later
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An analysis from CMIE ( this will be an project for a group)
What are pro-cyclical and what are counter cyclical and acyclical components of AD?

Among them which are leading, lagging and Coincident?

Consumption Pro-cyclical Counter- A-cyclical Leading Coincident Lagging
cyclical

Private Investment

Public Investment
Govt: expenditure

Net exports
Change in inventory

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What are the effects of AD shifts
In the short-run, shifts in aggregate demand affect causes economic
fluctuations or business cycles
 Business cycles are deviation from normal path
They vary in time and deviation
Analyzing the business cycles also means analyzing the components of AD
AD=C+I+G+NX
How much each component is driving short term growth ?
What are the respective weights of these components?

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AD and its decomposition
Understanding GDP growth means recognising where the growth comes
from
Identifies which sectors accounted for the growth? C, I, G, NX
Whether this growth from the sector is sustainable or not?
Step 1
How much growth is there in each component?
Step 2
How much is the weight of each component?
Policy maker understands which component growth contributed the
most of the growth in AD
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Mathematical representation of decomposition
Typically policy makers use growth rates

∆GDP/GDP =∆(C+I+G+NX)/GDP
Rate of growth of GDP = Change (C+I+G+NX)/GDP (STEP 1)
=∆C/C (rate of growth)*C/GDP(weight)+∆I(rate of
growth)/I*I/GDP(weight)+ ∆G/G(rate of growth)* G/GDP(weight)+
∆NX/NX (rate of growth)*NX/GDP(weight) ( STEP2)
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