econ 3 - Dr. Mohammed Alwosabi Econ 141 - Ch.3 Notes on...

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Dr. Mohammed Alwosabi Econ 141 - Ch.3 1 Notes on Chapter 3 AGGREGATE DEMAND AND AGGREGATE SUPPLY ± The AD-AS model determines RGDP and GDP Deflator and helps us understand the performance of three macroeconomic fundamentals: 1. Growth of potential GDP 2. Inflation 3. Business cycle fluctuations (expansion and recession) AGGREGATE DEMAND (AD) ± AD is the total amount of goods and services produced in a country (the quantity of RGDP demanded) that people, businesses, government, and foreigners are willing and able to buy at different price levels within a given period. AD = RGDP = Y = C + I + G + NX Aggregate Demand (AD) Curve ± The aggregate demand curve (AD) shows the inverse relationship between RGDP demanded and the price level (using either the GDP Deflator or CPI) when all other things remain the same. ± AD curve has negative slope (slopes downward) because of two effects: RGDP P P 0 P 1 AD Y 0 Y 1 0
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Dr. Mohammed Alwosabi Econ 141 - Ch.3 2 ± Wealth Effect: o Real wealth is measured as the amount of goods and services wealth will buy. o When price level increases but other things remain the same, real wealth decreases. To restore their wealth, people increase saving and decrease current consumption RGDP demanded decreases o Conversely, if the price level of goods and services fall but the value of your assets do not, you feel wealthier and may start consuming more RGDP demanded increases o Example: Suppose an individual holds BD50,000 in saving account. If the price level in Bahrain rises by 6%, then the individual’s real wealth decreases is worth less in terms of what it can purchase. As a result, consumption expenditure decreases and saving increases to restore the original wealth. ± Substitution Effect: 1. Inter-temporal substitution effect (interest rate effect): o The substitution effect involves substituting goods in the future for goods in the present or goods in the present for goods in the future. This is called inter-temporal substitution effect (a substitution across time). o This effect is mainly a result of changes in the real interest rate, which affect the decisions of households and businesses in terms of their willingness and ability to borrow.
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Dr. Mohammed Alwosabi Econ 141 - Ch.3 3 o As the price level falls, causing demand for money to decrease and interest rate to decrease, consumers may decide that it is not worth it to save since they do not receive as much return. On the other hand, they may decide that since it is now cheaper to borrow, they will increase their borrowing to finance their consumption and investment, which would increase RGDP demanded. The net effect of the decline of the interest rate is increasing present consumption and decreasing saving o Alternatively, when price level increases and other things remain the same, demand for money increases interest rate increases spending on consumption and investment decreases RGDP demanded decreases. Saving increases to increase future consumption
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econ 3 - Dr. Mohammed Alwosabi Econ 141 - Ch.3 Notes on...

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