Ch 15 Aggregate Demand and Aggregate Supply I The Aggregate Demand Curve Summarizes how the price level influences real GDP Why would change in the price level affect real GDP Think about money A The Price Level and the Money Market People hold money b c of convenience When we hold money we give up the interest we could have earned if we Assume the economy has just one interest rate and all assets pay that were holding other assets rate The money demand curve tells us how much of their wealth people want to hold as money at each interest rate If price level rises and our average purchase is more expensive people will need to hold more of their wealth as money just to achieve same convenience thus at any given interest rate the demand for money increases and the money demand curve shifts rightward shown in a for now assume Fed does not change money supply Ch 15 Aggregate Demand and Aggregate Supply w an unchanged money supply the rightward shift of the money demand curve in figure 2a will initially cause an excess demand for money which causes the interest rate to rise An increase in the price level w no change in the money supply shifts the money demand curve rightward and raises the equilibrium interest rate 1 Understanding Assumptions Assume a constant money supply help understand economy s self correcting mechanism B Deriving the Aggregate Demand Curve A change in price level can change the interest rate in the money market Now lets connect price level to equilibrium GDP In Figure 2a the money market is initially at equilibrium at Point A and interest rate is 6 Panel b shows initial position of Aggregate Expenditure line AEr 6 W this AE line equilibrium GDP is found at point E w output equal to 10 trillion Imagine a rise in price level from 100 to 140 What will happen in the economy Initial impact in money market Money demand curve will shift rightward and the interest rate will rise In panel b the higher interest rate decreases interest sensitive spending business investment new housing and consumer durables The AE line shifts downward and equilibrium GDP decreases Changes continue until reach a new consistent equilibrium Compares w initial position new equilibrium has following characteristics o Money demand curve shifted rightward o Interest rate is higher o The AE line shifted downward o Equilibrium GDP is lower All these changes caused by a rise in price level A rise in the price level with a constant money supply causes a decrease in Initial event that caused real GDP to fall rise in the price level equilibrium GDP In Panel c introduce new curve that shows negative relationship b t price level and equilibrium GDP Downward sloping curve AD Curve The Aggregate Demand Curve tells us the equilibrium GDP at any price level with a constant money supply C Understanding the AD Curve Each point on AD curve represents a short run equilibrium in the economy Ex Point H on the AD curve in figure 2 tells us when the price level is 100 equilibrium GDP is 10 trillion D Movements Along the AD Curve Whenever the price level changes move along the AD curve Ch 15 Aggregate Demand and Aggregate Supply Look at AD curve in panel c in Figure 2 suppose price level rises and we move from point H to point K along curve Then the following sequence of events happen the rise in the price level increases the demand for money raises the interest rate decreases autonomous consumption a and investment spending IP and works through the multiplier to decrease equilibrium GDP The opposite sequence of events occur if the price level falls moving us rightward along the AD curve E Shifts of the AD Curve 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 Things that cause AD curve to shift and equilibrium GDP to change o Government purchases o Taxes o Autonomous consumption spending o Investment spending o Net Exports o The money supply 1 An Increase in Government Purchases Equilibrium output is 10 trillion In figure 3 assume economy begins at price level of 100 Ch 15 Aggregate Demand and Aggregate Supply Government purchases increase by 1 trillion What will happen to equilibrium GDP assuming the price level remains at 100 If the MPC is 0 6 the value of the multiplier will be 1 1 0 6 2 5 Therefore GDP will rise by 1 trillion x 2 5 2 5 trillion Ch 15 Aggregate Demand and Aggregate Supply Our new value for equilibrium GDP is 12 5 trillion Shown in panel a of The Aggregate Expenditure line shifts upward to AE2 and the equilibrium figure 3 moves to point F With the price level remaining at 100 equilibrium increases Now look at panel b in figure 3 Where new equilibrium is represented by point J p 100 real GDP 12 5 trillion Point lies to the right of our original curve AD1 Point J there fore must lie on a new AD curve a curve that tells us equilibrium GDP at any price level after the increase in government spending The new AD curve is labeled AD2 which goes through point J Conclude an increase in government purchases shifts the entire AD curve rightward The AD curve shifts rightward when government purchases investment spending autonomous consumption spending or net exports increase or when net taxes decrease At any given price level a decrease in government spending shifts the aggregate expenditure line downward decreasing equilibrium GDP this in turn shifts the AD curve leftward 2 Changes in the Money Supply Changes in the money supply will also shift AD curve This will cause the interest rate to decrease increasing investment spending Imagine Fed increases the money supply and autonomous consumption spending Together these spending changes will shift the AE line upward just as in panel a figure 3 And increase equilibrium GDP B c this change in equilibrium output is caused by something other than a change in price level the AD curve shifts In this case because the money supply increased the AD curve shifts rightward just as in panel b in figure 3 An increase in the money supply shifts the AD curve rightward A decrease in the money supply would have the opposite effect the interest rate would rise the AE line would shift downward and equilibrium GDP at any price level would fall 3 Shifts v Movements along the AD curve A Summary Ch 15 Aggregate Demand and Aggregate Supply II The Aggregate Supply Curve Changes in output affect price level A Costs and Prices The price
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