How does demand and supply change when things happen in the economy, like: Inflation Unemployment Levels of spending Real output

We look at a concept called Aggregate Demand (AD): concept of demand applied to the economy as a whole to see the relationship between general price level and total spending

10.1 Aggregate Demand

Recall: total spending on goods & services in an economy: Consumption Investment Government Purchases Net Exports

The primary groups responsible for this spending are: Households Businesses Governments Rest of the World

Total spending in an economy: Real Expenditures

Aggregate Demand

As the general level of prices increases, less real output is bought for two reasons: 1. The real value of financial assets, such as bank

accounts and bonds, decreases. Households feel less wealthy, reduce consumption spending

2. Net export spending is reduced, as both foreigners spend less on Canadian exports and Canadian residents spend more on imports

Y-Axis: Price Level = GDP Deflator X-Axis: Real GDP

The Aggregate Demand Curve

Recall: price and quantity demanded of a product have an inverse relationship

Same can be said for general price level and real expenditures, but for different reasons: Quantity demanded explained using law of diminishing

marginal utility Amount spent in economy explained using wealth and

foreign trade effects

The Aggregate Demand Curve

Wealth: form of financial assets and real assets To find real value of financial assets:

When price level rises, the real value of households’ financial assets decreases

Consumers feel they have less wealth, so spend less on consumption items

As a result of this wealth effect, real expenditures drop

Wealth Effect

Changes in price level also influence foreign trade When price level in Canada rises, Canadian exports

become more expensive for foreigners Decrease in export expenditures Products imported into Canada become cheaper than

domestic products Foreign Trade Effect: involves a decrease

in exports (X – M), thus, a decline in real expenditures

Foreign Trade Effect

Recall: price level influences total spending (one factor)

Aggregate Demand Factors: change in total spending at all price levels – i.e. aggregate demand curve gets shifted

e.g. Government purchases increase, aggregate demand curve shifts right by amount (Y2 – Y1): Increase in Aggregate Demand

Decrease in a component of real expenditures causes a decrease in aggregate demand (curve shifts left)

Changes in Aggregate Demand

Factors can be categorized according to the spending component they immediately affect

Consumption – Disposable Income (DI) & Wealth Most significant determinant of consumer spending is

DI DI and consumption have a direct relationship A change in stocks will change wealth, which changes

consumption This changes aggregate demand

depending on a loss/gain (i.e. value of assets increases or debt increases)

Aggregate Demand Factors: Consumption

More consumption factors: Consumer expectation and interest rates

Consumer Expectations: if consumers expect prices to rise (e.g. due to a flood), or if they expect their income to rise they will spend more now and save less Higher consumer spending = aggregate demand

increases = aggregate demand curve shifts to the right Interest Rates: For purchasing big-ticket items, such as

cars or furniture, households often buy this on credit The lower the interest rate = more borrowing for these

items The higher the interest rate = consumer spending falls

Aggregate Demand Factors: Consumption

Investment: spending on a project where earning a profit is anticipated

For a business to decide whether or not to make an investment, they must calculate: All expected revenues and costs of project Calculate project’s real rate of return – constant-

dollar extra profit provided by the project each year A project is only undertaken, if annual benefit >

annual cost Now let’s look at the economy, and not just one

business

Aggregate Demand Factors: Investment

As real interest rate decreases, more investment projects are undertaken

If interest rate is 8%, only project A is carried out If interest rate is 6%, project B can be pursued as well Interest rates and investment have an inverse relationship Even business expectations can affect

position of demand curve – what the business anticipates will happen

Investment Demand: the relationship between interest rates and investment

Investment Demand Graph: ID on a graph

Aggregate Demand Factors: Investment

Rise in Gov’t purchases (e.g. highway construction) = increase in aggregate demand; fall in Gov’t purchases: decrease in AD

Aggregate Demand Factors: Government Purchases

Price level changes influence total spending in the economy Expressed as a movement along the aggregate demand

curve Things that cause a change in aggregate demand:

Foreign countries & foreign exchange rates The effects of changes in these factors is represented by a

shift in the aggregate demand curve If Foreign Incomes rise, other countries will import

more items from Canada, increasing Canada’s aggregate demand

If Exchange Rate changes, (e.g. Canadian dollar increases), foreign countries will most likely import less items because they will be more expensive

Aggregate Demand Factors: Net Exports