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ECON203 Principles of Macroeconomics

Week 8Topic: Aggregate Demand

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Learning outcomes for Learning outcomes for student revisionstudent revision

To learn aboutAfter studying these topics you should be able to:Understand the meaning and factors that affect

Aggregate Demand.

Show changes using an AD and explain their output and price implications

Explain the meaning and differences between Equilibrium output (Ye) and Potential output (YP) and why and how they will change

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Aggregate DemandAggregate Demand

• Aggregate Demand:It is the relationship between the quantity of real GDP demanded and the price level when other influences on expenditure plans remain the same.

• This relationship as follows:• Other things remaining the same, the higher the

price level , the smaller is the quantity of real GDP demanded; and the lower the price level, the greater is the quantity of real GDP demanded .

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Aggregate Demand Aggregate Demand Fundamentals Fundamentals

The quantity of real GDP demanded (Y) is the total amount of final goods and services produced in Saudi Arabia that people, businesses, governments, and foreigners plan to buy.

This quantity is the sum of planned:o consumption expenditures (C),o investment (I),o government spending (G), ando exports minus imports (net exports), (X – M).

That is: Y = C + I + G + (X – M) = GDP (expenditure measure)

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Aggregate Demand Curve Aggregate Demand Curve

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Aggregate Demand Curve - Aggregate Demand Curve - Downward slope. Downward slope.

“the higher (lower) the price level the smaller (greater) the quantity of real GDP demanded” when other things are constant. Because a change in the price level brings a change in: 1.The buying power of money 2. The real interest rate 3. The real prices of exports and imports

The buying power of money (Wealth Effect)A rise in the price level lowers the buying power of money. That means the same quantity of money can not buy the same quantity of goods and services as price level increases. As prices rise the buying power of your wealth ________ and the quantity of Saudi Arabia’s real GDP demanded ________

Drops

Decrease

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Aggregate Demand Curve - Aggregate Demand Curve - Downward slope Downward slope

•When the price level ( )demand for money (the amount of money that people want to hold) ( ), the nominal interest rate ( )the real interest rate ( ).• Faced with higher real interest rate, businesses and people delay plans to buy new capital and consumer durable goods and they will decrease spending.As prices rise the interest rate ________ and the quantity of Saudi Arabia’s real GDP demanded ________ .

Increase

Decrease

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Aggregate Demand Curve - Aggregate Demand Curve - Downward slope Downward slope

The Real Prices of Exports & Imports (Substitute Effects)

When the country's price level increases and the prices in other countries do not change local made goods and services will be more expensive than the foreign made items. People will spend less on local made items and that

means a decrease in real GDP demanded.

As prices rise export buyers will tend to buy________ and Saudi People will buy ______ imports, so the quantity of KSA’s real GDP demanded _________

LessMore

Decrease

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Aggregate Demand Curve - Aggregate Demand Curve - Downward slope Downward slope

Real GDP

Price Level

P3

Q3 Q1 Q2

AD

P1

P2

Price level ↑ moves us leftward along the AD curve

Price level ↓ moves us rightward along the AD curve

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Changes in Changes in Aggregate Aggregate Demand. Demand.

•A change in any factor other than the price level brings a change in aggregate demand and aggregate demand curve shifts to the right (aggregate demand increases)or to the left(aggregate demand decreases) .•The factors are :1.Expectations about the future (concerning economic, political and social factors) 2.Government Economic Policies (Fiscal and monetary policies)3.The state of the world economy (net exports)

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Changes in ADChanges in AD ( (Shift of the AD curve) for expectation) for expectation

1) Expected higher future income-AD (Rightward)2) Expected lower future income-AD (Leftward)3) Expected higher future inflation-AD (Rightward)4) Expected lower future inflation-AD (Leftward)5) Expected higher future profits-AD (Rightward)6) Expected lower future profits-AD (Leftward)

With same price level

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Changes in ADChanges in AD ( (Shift of the AD curve) ) for government for government

policiespolicies

1) Expansionary fiscal policy (tax ,G ,TP )-AD (Rightward)

2) Contractionary fiscal policy (tax ,G ,TP )-AD (Leftward)

3) Expansionary monetary policy (i MS ) -AD (Rightward)

4) Contractionary monetary policy(i MS )-AD (Leftward)

With same price level

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Changes in AD Changes in AD ((Shift of the AD curve) for state of the world economy) for state of the world economy

1) Better world economy (foreign income )-AD (Rightward)

2) Worse world economy (foreign income )-AD (Leftward)

3) Lower exchange rate (X M ) -AD (Rightward)

4) Higher exchange rate (X M ) -AD (Leftward)

With same price level

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Changes in ADChanges in AD ( (Shift of the AD curve))

Entire AD curve shifts rightward if:• a, I, TP, G, or NX increases• Net taxes, i decrease• The money supply increases

AD2

AD1

Real GDP

Price Level

Entire AD curve shifts leftward if:• a, I, TP, G, or NX decreases• Net taxes, i increase• The money supply decrease

AD1

AD2

Real GDP

Price Level

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Macroeconomic Equilibrium Macroeconomic Equilibrium (short-run)(short-run)

Occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied at the point of intersection of the AD curve and the SAS curve.i.e. AD = SAS shows where the economy is NOW

Only at this combination of prices and production can firms sell all their output and people buy all the goods and services they demand.

Short-run equilibrium is the normal state of the economy as it fluctuates around potential GDP.

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Short-Run Equilibrium – GraphShort-Run Equilibrium – Graph

AD

SAS

Short-runmacroeconomicequilibrium

0

85

115

95

105

125

860 900 940 880 920Real GDP

Price Level

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Explaining Macroeconomic Explaining Macroeconomic Fluctuations Fluctuations

– Figure 10.6 illustrates a short-run equilibrium.

– If real GDP is below equilibrium GDP, firms increase production and raise prices…

– … and if real GDP is above equilibrium GDP, firms decrease production and lower prices.

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What Happens When Things What Happens When Things Change?Change?

Our short-run equilibrium will change when either AD curve, SAS curve, or both, shift An event that causes AD curve to shift is called a

demand shock. An event that causes AS curve to shift is called a

supply shock.

A change in spending by one or more sectors that ultimately affects entire economy

Demand shocks and supply shocks are just two different categories of spending shocks

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The Effect of a Demand Shock The Effect of a Demand Shock in short-runin short-run

Price Level

Real GDP($ Trillions)

100

130

SAS

1012.5

13.5

E

J

H

AD1

AD2

115

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An Increase in Government Purchases

An Increase in Money Supply

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Inflationary and Recessionary Inflationary and Recessionary GapGap

– The amount by which real GDP exceeds potential GDP is called a inflationary gap.

– The amount by which real GDP is less than potential GDP is called a recessionary gap.

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Question 1: Home Work Question (4 marks)Using the AD/AS model, show and explain (using four separate diagrams) the likely impact of the following events on KSA’s prices and output. Consider the economy initially at full employment.i.Consumer confidence strengthens

ii.The world experiences a strong resources price boom.

iii.Oil prices fall substantially

iv.There’s a significant technological development and improvement.

Thinking time…………………..

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Question 2: Home Work Question (4 marks)

Draw on an AD/AS graph the expected impacts of the following factors and explain the effects on the economy. (a)A falling stock market(b)Increasing labour market participation

Thinking time…………………..

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Now it’s over for Now it’s over for today. Do you have today. Do you have any question?any question?