• Aggregate Demand - a schedule that shows how much goods and services people want to buy and the price level
  • Total goods and services is GDP
  • Price level - index of all prices for final goods and services
• AD Function has a negative slope
  • Not a demand function!
  • Why the negative slope?
    1. Real balance effect - the value of people's money, savings and investment after adjusting for inflation
       • A high price level results from inflation
         • Inflation - price level is increasing
       • Inflation reduces the value of money, savings, and investments like stocks and bonds
         • Lower GDP
       • At a lower price level, people have a higher real balance effect and spend more on goods and services
    2. Interest rate effect - more complicated
       • Money in economy is fixed (until central bank increases it)
       • At higher price levels, people lower the amount of savings to financial institutions
         • Interest rates have to be high to attract funds
         • i.e. Fisher Equation
       • At higher interest rates, businesses and people invest less in structures, machines, and equipment
         • Lower GDP
         • Note - The price level impacted interest rates
    3. Foreign purchases effect - how one country's price level compares to another country
       • The U.S. price level increases relative to another country
       • Exchange rates did not change; price level impacts exports and imports directly 
       • Americans increase imports, because they are cheaper
       • Foreigners decrease exports, because they are more expensive
• Aggregate Demand is shown below

• Shifts in Aggregate Demand
• Consumers
  1. Consumer spending - consumers decide to save less income and consume more, thus increasing (shifting right) the aggregate demand function
  2. Real Wealth - if consumers wealth increases, consumers spend more, aggregate demand shifts right
     • Stock prices dropped significantly during 2008
     • People have lower wealth because pension plans and investments are lower in value
     • Aggregate demand shifts left
  3. Consumer expectations
     • If consumers are optimistic about the future, they may spend more now, increasing aggregate demand
     • If consumers are pessimistic about the future, they may reduce their spending
       • If a consumer is expecting layoffs, a tough job market, etc., he is more likely to reduce spending and increase savings
  4. Household debt -
     • If households have low debt, they can increase their spending by borrowing more, causing aggregate demand to shift right
     • If households have high debt, they may lower their spending in order to pay it back, decreasing aggregate demand
  5. Taxes
     • Government increase taxes, disposable income falls, so households have to consume and save less, AD shifts left
     • Government decreases taxes, disposable income increase, so households can consume and save more, thus, AD shifts right
• Investment
  1. Real interest rates
     • Households - invest in more new houses, new cars, and appliances, when real interest rates are low
       • Not caused by a change in price level
     • Businesses - invest in more structures, machines, and equipment
       • AD increases and shifts right
  2. Expected Returns (or Profits) - businesses invests more if they expect future profits
     1. Businesses are optimistic about the future business climate
        • Economy is growing along with consumers' demands
     2. Businesses adopt new technologies
        • Technology lowers production costs, increases workers' productivity, or increases quality
     3. Businesses are using their capital at full capacity
        • Businesses invest in more capital in order to increase the capacity level
     4. Taxes - if government decreases taxes, then businesses may invest more
• Government - government is a large sector of economy
  • If government increases spending, then AD increases and shifts right
  • If government decreases spending, then AD decreases and shifts left
• International sector
  • Not caused by a change of the price level
  • If net exports increase
    • Either exports increase and/or imports decrease
    • More products and services are produced here and exported, causing AD to shift right
  • Foreign income - if a foreign country becomes richer, they import more
    • Our exports increase, causing AD to shift right
  • Exchange rates
    • If U.S. dollar appreciates (or becomes stronger), then
      • Exports decrease
      • Imports increase
      • AD shifts left

Equilibrium - state of rest; nothing changes

• Price level and level of GDP do not change
• At P', businesses and producers produce at Q₁ while consumers want to buy Q₂
  • Consumers bid up prices until the price level is at P*

• At P" businesses and producers produce at Q₂ but consumers want to buy Q₁
  • Inventories are increasing
  • Businesses reduce prices to sell inventories and cut back on production
    • Price level falls until it equals P*

Case 1 - AD increases and shifts right

• Businesses increase investment
• Government increases spending or lowers income taxes
• If the economy was at full employment (FE) and AD increases
  • GDP increases
  • Price level increases
• Creates Demand Pull Inflation

Case 2 - AD decreases and shifts left

• Business investment decreases
• Government decreases spending (not typical)
• Government increases taxes on incomes
• Note - prices in an economy tend not to decrease
  • If prices could fall (deflation), then economy is in a recession at Q₁
  • If prices do not fall, then economy is in a recession at Q₂
    • The recession is worse

• Why prices do not fall?
  • Companies do not want to start a price war
    • Price wars destroy profits, as companies keep trying to under cut each other
  • Menu costs - changing prices imposes additional costs on companies
    • If firms believe recession will be short live, they may not lower their prices
    • Menu costs
      • Cost of printing new catalogs, menus, etc.
      • Cost to re-price merchandise that is in inventory
      • Cost to communicate prices to consumers
        • Consumers get angry if prices change suddenly or unexpectedly
  • Labor is a major cost and firms may not be able to lower workers' wages
    • Wage contracts - companies and workers agreed to wages specified in a contract
    • Efficiency wages - wages reflect a worker's level of productivity
      • Lowering wages may decrease workers' morale and work habits, potentially lowering workers' productivity
    • Minimum wage laws - firms cannot lower wages below the minimum wage

Case 3 - AS decreases and shifts left

• War
• Natural disaster
• Energy price shock
  • Example is OPEC
• Leads to lower output and a higher price level
  • Cost Push inflation
  • Stagflation

Case 4 - AS increases and shifts right

• Producers adopt new technology
• Increased immigration, which lowers wages
• Output increases
  • If prices could fall, then economy grows to Q₁
  • If prices are rigid, then economy grows larger to Q₂
    • Prices may not fall because of the reasons for Case 2

If an economy has rigid prices, where prices cannot fall, then changes can have a much larger impact on the economy.