University of Liberal Arts Bangladesh

(ULAB)
School of Business

MBA Programme
Fall 2014
Macroeconomics
Lecture note: 2

Course Teacher:
Shish Haider Chowdhury
shishchowdhury@yahoo.co.uk
Cell: 018 19225594

26 September 2014

Aggregate Demand
In macroeconomics, aggregate demand (AD) is the total demand for final
goods and services in the economy (Y) at a given time and price level.
It is the amount of goods and services in the economy that will be purchased
at all possible price levels. This is the demand for the gross domestic product
of a country when inventory levels are static. It is often called effective
demand, though at other times this term is distinguished.
It is often cited that the aggregate demand curve is downward sloping
because at lower price levels a greater quantity is demanded. While this is
correct at the microeconomic, single good level, at the aggregate level this is
incorrect. The aggregate demand curve is in fact downward sloping as a
result of three distinct effects:

Pigou's wealth effect: The Pigou effect was first popularised by

Arthur Cecil Pigou in 1943. The Pigou effect is the wealth effect on
consumption as prices fall. A lower price level leads to a
greater existing private wealth of nominal value, leading to a
rise in consumption.

Keynes' interest rate effect: The Keynes effect is a term used in

economics to describe a situation where a change in interest rates
affects expenditure more than it affects savings. As prices fall, a
given nominal amount of money will become a larger real
amount. As a result the interest rate will fall and investment
demanded rise. This means that insufficient demand in the product
market cannot exist forever.

Mundell-Fleming exchange-rate effect: The Mundell-Fleming

model is an economic model first set forth by Robert Mundell and
Marcus Fleming. Typically, the Mundell-Fleming model portrays the
relationship between the nominal exchange rate and an economy's
output in the short run. The Mundell-Fleming model has been used to
argue that an economy cannot simultaneously maintain a fixed
exchange rate, free capital movement, and an independent monetary
policy.

Components of aggregate demand

An aggregate demand curve is the sum of individual demand curves for
different sectors of the economy. The aggregate demand is usually described
as a linear sum of four separable demand sources.
Yd= C+I+G+ (X-M)
where
C is consumption,
I is Investment,
G is Government spending,
(X-M) is Net export,
X is total exports, and
M is total imports.

C= Consumers' expenditure on goods and services: This includes demand

for durables & non-durable goods.
I= Gross Domestic Fixed Capital Formation - i.e. investment, spending
by companies on capital goods. Investment also includes spending on
working capital such as stocks of finished goods and work in progress.
G= General Government Final Consumption. i.e. Government spending
on publicly provided goods and services including public and merit goods.
Transfer payments in the form of social security benefits (pensions, jobseekers allowance etc.) are not included as they are not a payment to a
factor of production for output produced. A substantial increase in
government spending would be classified as an expansionary fiscal policy.
X= Exports of goods and services - Exports sold overseas are an inflow of
demand into the circular flow of income in the economy and add to the
demand for UK produced output. When export sales from the UK are healthy,
production in exporting industries will increase, adding both to national
output and also the incomes of those people who work in these industries.
M= Imports of goods and services. Imports are a withdrawal (leakage)
from the circular flow of income and spending in the economy. Goods and
services come into the economy - but there is a flow of money out of the
economic system. Therefore spending on imports is subtracted from the
aggregate demand equation.
Note: X-M is the current account of the balance of payments

The Aggregate Demand Curve

Understanding of the aggregate demand curve depends on whether it is
examined based on changes in demand as income changes, or as price
change.
Aggregate demand curves: price changes
Aggregate demand normally rises as the price level falls. This can be
explained in three main ways:

As the price level falls, the real value of money balances held increases.
This increases the real purchasing power of consumers.
Prices and interest rates
A lower price level increases the real interest rate - there will be pressure on
the monetary authorities to cut nominal interest rates as the price level falls.
Lower nominal interest rates should encourage an increase in consumer
demand and planned investment.
International competitiveness
If the UK price level is lower than other countries (for a given exchange rate),
UK goods and services will become more competitive. A rise in exports adds
to aggregate demand and therefore boosts national output.

Shifts in Aggregate Demand

A change in one of the components of aggregate demand will cause a shift in
the aggregate demand curve. For example there might be an increase in
export demand causing an injection of foreign demand into the
domestic economy. The government may also increase its own expenditure
and businesses may raise the level of planned capital investment
spending.

Aggregate demand curves: income level changes

Keynesian cross
In the "Keynesian cross diagram," a desired total spending (or aggregate
expenditure, or "aggregate demand") curve is drawn as a rising line since
consumers will have a larger demand with a rise in disposable income, which
increases with total national output. This increase is due to the positive
relationship between consumption and consumers' disposable income in the
consumption function. Aggregate demand may also rise due to increases in
investment (due to the accelerator effect), while this rise is reduced if imports
and tax revenues rise with income. Equilibrium in this diagram occurs where
total demand, AD, equals the total amount of national output, Y, (which
corresponds to total national income or production). Here, total demand
equals total supply.

Aggregate Demand Curve

Why the Aggregate-Demand curve is downward sloping

1. The Price Level and Consumption: The Wealth Effect

A lower price level raises the real value of money and makes
consumers wealthier, which encourages them to spend more;
This increase in consumer spending means larger quantities of goods
and services demanded.

2. The Price Level and Investment: The Interest Rate Effect

A lower price level reduces the interest rate and makes borrowing less
expensive, which encourages greater spending on investment goods;
This increase in investment spending means a larger quantity of goods
and services demanded.

3. The Price Level and Net Exports: The Exchange-Rate Effect

A lower price level in the UK causes UK interest rates to fall and the
real exchange rate to depreciate, which stimulates UK net exports;
The increase in net export spending means a larger quantity of goods
and services demanded.

Aggregate supply
Defining aggregate supply
Aggregate Supply (AS) measures the volume of goods and services produced
within the economy at a given overall price level. There is a positive
relationship between AS and the general price level. Rising prices are a signal
for businesses to expand production to meet a higher level of AD. An increase
in demand should lead to an expansion of aggregate supply in the economy.
Short-run aggregate supply
Aggregate supply is determined by the supply side performance of the
economy.
It reflects:

the productive capacity of the economy; and

the costs of production in each sector.

Shifts in the AS curve can be caused by the following factors:

changes in size & quality of the labour force available for production;
changes in size & quality of capital stock through investment;
technological progress and the impact of innovation;
changes in factor productivity of both labour and capital;
changes in unit wage costs (wage costs per unit of output);
changes in producer taxes and subsidies; and
changes in inflation expectations - a rise in inflation expectations is
likely to boost wage levels and cause AS to shift inwards.

In the diagram above - the shift from AS1 to AS2 shows an increase in
aggregate supply at each price level might have been caused by
improvements in technology and productivity or the effects of an increase in
the active labour force.

An inward shift in AS (from AS1 to AS3) causes a fall in supply at each price
level. This might have been caused by higher unit wage costs, a fall in capital
investment spending (capital scrapping) or a decline in the labour force.
Long run aggregate supply
Long run aggregate supply is determined by the productive resources
available to meet demand and by the productivity of factor inputs (labour,
land and capital).
In the short run, producers respond to higher demand (and prices) by
bringing more inputs into the production process and increasing the
utilization of their existing inputs. Supply does respond to change in price in
the short run.
In the long run we assume that supply is independent of the price level
(money is neutral) - the productive potential of an economy (measured by
LRAS) is driven by improvements in productivity and by an expansion of the
available factor inputs (more firms, a bigger capital stock, an expanding
active labour force etc). As a result we draw the long run aggregate
supply curve as vertical.

Shift in Long Run Aggregate Supply Curve

Improvements in productivity and efficiency cause the long-run aggregate
supply curve to shift out over the years. This is shown in the diagram
below

Short-Run Equilibrium
The equilibrium in the short-run is shown by the intersection of the
Aggregate Demand (AD) curve and the Short-Run Aggregate Supply (SAS)
curve. When either AD or SAS shifts, the equilibrium point is changed. For
example, in Graph 1, a shift to the right of the AD curve will cause the
equilibrium output as well as the price level to increase. And if the AD curve
were to shift to the left, as in Graph 2, the opposite would be true: output and
price level will decrease.

Graph 1

Graph 2

A shift to the left in SAS, as shown in Graph 3, will cause the price level to rise
while equilibrium output will decrease. And a shift to the right, as shown in
Graph 4, will decrease price level and increase output.

Graph 3

Graph 4
Long-Run Equilibrium
The equilibrium in the long-run is shown by the intersection of the AD
curve, the SAS curve, and the Long-Run Aggregate Supply (LAS) curve. Since
LAS represents potential output, a shift in the AD curve will only result in a
change in price level: a shift to the right increasing price level and a shift to
the left decreasing price level. If an economy is said to be in long-run
equilibrium,

then

Real

GDP

is

at

its

potential

output,

the

actual

unemployment rate will equal the natural rate of unemployment (about 6%),
and the actual price level will equal the anticipated price level.