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Chapter+12+-Aggregate+Demand+Function-1

Chapter+12+-Aggregate+Demand+Function-1 - Study Guide To...

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Chapter 12 Study Guide To Accompany Macroeconomics: Theory and Policy By B. Modjtahedit Prepared by T. J. McCarthy and B. Modjtahedi University of California, Davis
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Key Points Aggregate demand function gives the combinations price and GDP levels at which both the money and goods markets are in equilibrium. Aggregate demand function is downward sloping for three reasons. They are: The wealth effect The foreign trade effect The Interest rate effect
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Key Points The wealth effect : All else being the same, a reduction in the general price level increases the purchasing power of household wealth, stimulating consumption and pushing up the aggregate demand. To clear the goods market, the real GDP must increase. Similarly, for an increase in the price level. P↓ (A/P)↑ C↑ AD↑ Y↑ (Multiplier) P↑ (A/P)↓ C AD Y (Multiplier) P 80 90 100 110 120 10 20 30 40 50 60 70 80 90 100 Y AD
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Key Points Foreign trade effect : All else being the same, a reduction in the general price level makes domestic goods cheaper than foreign goods. Net exports increases pushing up the aggregate demand. To clear the goods market, the real GDP must increase. Similarly, for an increase in the price level. P↓ (X M)↑ AD↑ Y↑ (Multiplier) P↑ (X M )↓ AD Y (Multiplier) P 80 90 100 110 120 10 20 30 40 50 60 70 80 90 100 Y AD
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Key Points Interest rate effect : All else being the same, a reduction in the general price level reduces the quantity of money demanded, and hence the rate of interest. This stimulates consumption and investment spending, pushing up the aggregate demand. To clear the goods market, the real GDP must increase. Similarly, for an increase in the price level. P 80 90 100 110 120 10 20 30 40 50 60 70 80 90 100 Y AD P↓ M d r↓ AD↑ Y↑ (Multiplier) (C + I)↑ P M d r AD Y (Multiplier) (C + I)
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Key Points Points Off : At any point off the AD function either the goods market, or the money market, or both are out of equilibrium. This book will assume that the money market always clears. So if the economy is off the AD function, the goods market must be out of equilibrium. P 80 90 100 110 120 10 20 30 40 50 60 70 80 90 100 Y AD Excess supply of goods Y > AD Excess demand for goods Y < AD
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ΔY = Multiplier × ΔAD Key Points Shifts in the AD Function : Any change in the components of aggregate demand that is not the result of a change in P will cause a shift in the AD function. Note: Δ Y is the amount of horizontal shift in the AD function. P 80 90 100 110 120 10 20 30 40 50 60 70 80 90 100 Y AD Any event that increases a component of aggregate demand (C, I, G, or X M), except a change in P. Any event that decreases a component of aggregate demand (C, I, G, or X M), except a change in P. ΔY = Multiplier × ΔAD
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Key Points Fiscal Policy: Keynesians do not generally believe in the notion of financial crowding out. Therefore, in the Keynesian model, an expansionary fiscal policy will shift the AD function to the right. The following shows the magnitude of the horizontal shift under different polices.
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