12.1 Aggregate Demand

What is aggregate demand (AD)?

A curve showing the total quantity of real GDP demanded at different price levels by households, businesses, governments, and foreign buyers.

What kind of relationship exists between the price level and real GDP demanded?

Inverse — as the price level rises, real GDP demanded falls; as the price level falls, real GDP demanded rises.

What does the real-balances effect explain?

How changes in the price level affect consumer spending by changing the purchasing power of nominal balances.

What happens when the price level rises? (real-balances)

Real balances fall → purchasing power declines → consumer spending decreases → AD decreases.

What happens when the price level falls? (real-balances)

Real balances rise → purchasing power increases → consumer spending increases → AD increases.

Why does this affect AD? (real-balances)

Because consumption (C) is a component of aggregate demand.

What does the interest-rate effect explain?

How a higher price level increases money demand, raises interest rates, and reduces investment and consumption.

What happens when the price level rises? (interest-rate)

Money demand increases → interest rates rise → investment (I) and interest-sensitive consumption fall → AD decreases.

What happens when the price level falls? (interest-rate)

Money demand decreases → interest rates fall → investment and consumption rise → AD increases

What does the foreign purchases effect explain?

How changes in the domestic price level affect net exports (Xₙ).

What happens when the U.S. price level rises relative to other countries?

U.S. exports fall, imports rise → net exports decrease → AD decreases.

What happens when the U.S. price level falls?

U.S. exports rise, imports fall → net exports increase → AD increases.

What are the three effects that explain the downward slope of the AD curve?

1. Real-Balances Effect

2. Interest-Rate Effect

3. Foreign Purchases Effect

The _________ occurs when a higher price level reduces the purchasing power of the public's accumulated savings balances.

Real balances effect

When a higher price level increases the demand for money, which will drive up the price paid for its use, assuming a fixed money supply, it is called the ______ effect.

Interest-rate

As price level goes up…

Demand for money goes up

As demand for money goes up…

Interest rates go up

As interest rates go up…

Borrowing, investment, and consumption go down

As consumption goes down..

Aggregate demand goes down

When price level falls…

GDP will go up

Changes in consumer spending, investment, government spending and net export spending will ______

Shift the aggregate demand curve