Saturday, January 30, 2010

Aggregate Demand




We know that National Income is a function of Aggregate Expenditure. Thus far, we have been assuming that prices remain constant...

Newsflash! In real life, prices change (unless the firms contributing to GDP are monopolies, or they have excess capacity). We need to look at how this affects aggregate expenditure, and subsequently, national income.

We assume that output is demand-determined: that is, GDP will rise if general consumer demand rises, and it will fall with decreases in demand

OKAY: How does price affect aggregate demand? Well, it affects it in an inverse relationship. When the price level increases, aggregate expenditures shift down. When the price level decreases, aggregate expenditures shift up! Why?

2 Reasons:

1: A Decline in Wealth
An increase in price levels causes people's wealth to decrease (unless they have invested into price-variable assets, which most people have not)- inflation decreases the purchasing power of money. Wealth is a ceteris paribus variable for consumption When wealth goes down, peoples' desire to spend (their MPC) also decreases.

2: A Decline in Net Exports
An increase in domestic price levels implies that relatively speaking, foreign products will be cheaper than domestic products. The increases the incentive for domestic consumers to import foreign goods, and it also decreases the incentive for foreign consumers to buy domestic goods. As a result, imports increase (cutting into MPSpend) and exports decrease (lowering autonomous expenditures)

The overall effect is that AE and Prices are negatively related...

SO, what happens when we take the same Aggregate Expenditure curve, and then change the price several times? Well, the equilibrium level of national income will be different for each curve (higher price levels lead to lower expenditures, and therefore lower national income)

When you put together ALL of the different equilibrium income levels for AE, and then graph them in relation to price, you have the Aggregate Demand function!

The Aggregate Demand function is a family of equilibrium national income levels for different price levels! Every point on the AD function is a different equilibrium level.
-The Y-axis is price, and the X-axis is equilibrium national income
-It is downward sloping (As price decreases, equilibrium national income increases)
-Generally speaking, points which are not directly ON the AD function tend to gravitate towards it (because it is a stable equilibrium)
-If income for a certain price level is to the left of the AD curve, it means that for that price level, there is not enough production to satisfy expenditure demands. There are two solutions: firms can make more product (and horizontally move towards the AD curve) or they can raise prices (and vertically move towards the AD curve). More likely, it will be a combination of the two

Shifts in AD are called aggregate demand shocks, and are caused by changes in exogenous, autonomous expenditure (which consequently shifts the whole family of aggregate expenditure curves which we use to derive aggregate demand). If the family of expenditure curves increases, aggregate demand shifts to the right. If the family of expenditure curves decreases, aggregate demand shifts to the left.

The simple multiplier can be used to determine the horizontal shift in AD caused by a demand shock- you just multiply the shock by the simple multiplier, and the AD graph will shift out by that amount for that specific prices level

That's all for this section

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