Notes%20AD%20AS%20Model%200607[1] - 1 AGGREGATE DEMAND...

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AGGREGATE DEMAND AGGREGATE SUPPLY (AD-AS MODEL) (Sloman 5e pages 411- 414, 588- 595) (Sloman 6e pages 405- 407, 574- 581) Level of prices in an economy determined by interaction of aggregat e demand and aggregat e supply Variable- price- level-model: enables us to analyze changes in both real GDP and the price level simultaneously (AD/AS Model) Fixed- price- level- model: emphasizes changes in real GDP; doesn’t say anything about price levels (and inflation as an extension) (AE Model) AGGREGATE DEMAND Aggregate Demand – a schedule or curve that shows the amounts of real output that buyers collectively desire to purchase at each possible price level; total level of spending in an  economy AD = C + I g  + G + X n Inverse relationship between real GDP and Price Level Price Level Real GDP Demanded Price Level Real GDP Demanded Demand curve for a single product slopes downward basically due to Income Effect  and  Substitution Effect . Income Effect for S/D If Price of individual product  decreases, nominal income allows greater purchases  (Demand increases); reverse is also true Substitution Effect for S/D If the Price of an individual  product decreases, more of the product is  demanded as it becomes relatively less  expensive than other goods 18363c57e68a3a31fb1637a287a2967f607f3061.doc   24 Apr 07 1
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In Aggregates, as an economy moves down the Aggregate Demand curve, it moves to a general  lower price level. 1. A decline in price level need not produce an income effect since wages, rents,  interest, and profits (nominal income) would  decrease 2. Also, there is NO overall substitution effect among domestically produced goods  when the price level falls (as the general price level falls for all goods and services A Price Level change causes consumers to reduce or increase spending due to: 1. Real-Balances Effect (real money balances effect): A higher price  level means less consumption spending; a higher price level reduces the real value (or  purchasing power) of the public’s accumulated saving balances; purchases (especially for  ‘big ticket’ items) may be deferred (since they feel poorer) 2. Interest-Rate Effect: Assuming the supply of money is fixed, a  higher price level increases the demand for money and, consequently, the interest rate  increases, reducing the amount of real output demanded since higher interest rates curtail  investment spending (I) and interest-sensitive consumption spending (see following graphs on loanable funds, i/r and I relationship) 3. Foreign-Purchase Effect (international substitution effect): A rise in  the price level reduces the quantity of domestically produced goods demanded as exports 
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