Section 01: Aggregate Demand

Supply of real money and the demand for real money (by dividing both sides by the price level): Ms/P = L(R,Y). This equilibrium condition will yield an equilibrium nominal interest rate R. Finally, the definition of the money supply adopted here includes sterling deposits of non-residents as well as residents, on the grounds that some non-resident deposits are working balances held for trading purposes and thus affect expenditure in the U.K., and even purely investment balances will affect expenditure in the U.K.

As discussed in the previous lesson, the aggregate expenditures model is a useful tool in determining the equilibrium level of output in the economy. It does have a significant flaw, however: the aggregate expenditures model does not take into account the impact of the price level on aggregate output. The Aggregate Demand Curve (AD) represents, in that sense, an even more appropriate model of aggregate output, because it shows the various amounts of goods and services which domestic consumers (C), businesses (I), the government (G), and foreign buyers (NX) collectively will desire at each possible price level. Let’s begin by showing the relationship between the aggregate expenditures model and the AD curve.

In the graph below, we show the standard aggregate expenditures curve at three different price levels. When prices are high (P1), Consumption is low; as prices fall to P2 and P3, Consumption rises. As the Consumption function shifts upward due to the falling prices, the equilibrium level of GDP goes up from GDP1 to GDP3. This is depicted in the AD framework as a downward sloping AD curve.

Why does it make sense for the AD curve to slope downward and to the right? We will suggest three different rationales for the downward sloped curve: the real balances effect, the interest rate effect, and the foreign purchases effect.

Given the average price level, the nominal money supply (M S) divided by the average price level (P) defines the real money supply (m S). The following figure shows the real money supply as a perfectly inelastic curve. Additionally, the central bank controls the nominal money supply.
The Money Supply, the Price Level, and the Balance of Payments I n Chapter 16,we considered the impact of changes in the exchange rate alone on the balance of payments. In effect, income was held constant. In Chapter 17 we allowed income to vary. Similarly, the interest rate was held constant in Chapter 17; then it too was allowed to vary in.

The Real Balances Effect

“Real balances” refers to the purchase power of a given amount of money in circulation. We make the assumption that at any given point in time, there is a fixed amount of money in circulation. At higher price levels, the money in circulation can purchase fewer items. Think of the simple of example of having $1,000 in circulation and the average price of the goods and services in the economy being $10. A total of 100 items could be purchased under these conditions. If the average price level were to rise to $20 per item, then the $1,000 in circulation would only allow us to purchase 50 items. At higher prices, the money in circulation will spread over fewer goods. When prices fall, the purchasing power of the money in circulation goes up, and people can buy more goods and services. This relationship between prices and the amount of goods and services that can be purchased with a given money supply is called the real balances effect. It justifies our depiction of the AD curve as a downward sloping curve.

The Interest Rate Effect

The interest rate effect explains impact that the price level has on interest rates, and thus on certain components of AD. When the price level goes up, people need more money to transact their daily purchases. Therefore, higher prices lead to an increase in the demand for money. With a fixed amount of money in circulation, increasing the demand for money will cause the interest rate to go up. Think of how you would behave if you were running a bank and the demand for money increased. You would try to encourage additional people to deposit money into the bank, and at the same time discourage people from coming into the bank to demand money. The way to do both simultaneously would be to increase the interest rate. As interest rates go up, investment demand and certain interest-rate sensitive consumption purchases will fall. Thus, increases in the price lead to increases the interest rate, which reduces the demand for both Consumption and Investment, and thus real output. The interest rate effect is therefore an additional justification for the downward sloping AD curve.

The Foreign Purchases Effect

Domestic prices also have an impact on Net Exports (NX) through what is called the foreign purchases effect. When US prices rise relative to world prices, foreigners buy fewer US goods and Americans buy more foreign goods, so NX fall. Since NX are part of AD, this contributes to an inverse relationship between the price level and the demand for our real domestic output. The opposite is also true. The foreign purchases effect contributes to our argument for why the AD is downward sloping.

Anything that changes the price level triggers these three effects and is represented by movement along a given AD curve. There are other factors that influence aggregate demand besides the price level, and these factors are referred to as determinants of AD. When these other factors change, they cause a shift in the entire AD curve and are sometimes called aggregate demand shifters. These aggregate demand shifters include anything that will influence the levels of Consumption, Investment, Government Spending, or Net Exports OTHER THAN changes in the price level. Let’s consider each in turn.

Section 02: Aggregate Demand Shifters

The graph below illustrates what a change in a determinant of aggregate demand will do to the position of the aggregate demand curve. As we consider each of the determinants remember that those factors that cause an increase in AD will shift the curve outward and to the right and those factors that cause a decrease in AD will shift the curve inward and to the left.

Changes in Consumption unrelated to a change in the price

There are several factors that could increase or decrease consumption that are unrelated to changes in the price level. For instance, increases in consumer wealth would increase consumption at each price level and would be illustrated by a rightward shift in AD. Decreases in consumer wealth would have the opposite effect. Increases in consumer indebtedness would decrease consumption and shift the aggregate demand curve to the left, while decreases in indebtedness would have the opposite effect. Increases in taxes will decrease consumption (and shift the AD curve to the left) while decreases in taxes will increase consumption and shift the AD curve to the right. Consumer expectations about the future of the economy can have a strong impact on consumptions. Optimism about the economy will increase consumption and shift the AD curve to the right, while widespread pessimism dampens consumer spending and shifts the AD curve to the left. You can probably think of other factors that will shift the AD curve because they impact consumption independent of the price level.

Changes in Investment unrelated to a change in the price

There are several factors unrelated to changes in the price level that could increase or decrease Investment and thereby shift the AD curve. For instance, any change in the interest rate not brought about by a change in the price level would change the level of investment in the economy, and shift the AD curve. Increases in the interest rate will reduce investment demand; decreases in the interest rate will increase investment demand. Business taxes can be structured to either encourage investment (shifting the AD to the right) or discourage investment (shifting AD to the left). Technological improvements in an industry might make old equipment obsolete and stimulate investment, shifting AD to the right. Finally, like the impact of expectations on consumers, optimism (or pessimism) on the part of business owners can lead to increases (or decreases) in investment activity and shift the AD curve to the right (or left).

Changes in Government Spending unrelated to a change in the price

The political process will sometimes lead to increases or decreases in the level of government spending. Increases in government spending will shift the AD curve to the right; decreases in government spending will shift the AD curve to the left.

Changes in Net Exports unre

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