Aggregate Demand Notes

Introduction to Aggregate Demand

The Aggregate Demand Curve

  • Aggregate Demand (AD): The total amount of spending on domestic goods and services in an economy.

  • Conceptually, aggregate demand is a theoretical construct, aggregating the demand for all goods in all markets to determine how much a population can purchase at each price level.

  • Aggregate Demand (AD) Curve: A curve that shows the total spending on domestic goods and services at each price level.

  • Price Level: The average of current prices across the entire spectrum of goods and services produced in an economy; also a theoretical construct.

  • Real Product: The total quantity of "stuff" bought in an economy, regardless of price.

Components of Aggregate Demand

  • Aggregate Demand can be divided into four main parts:

    • Consumer Spending (Consumption): Goods and services bought to satisfy wants and needs.

    • Business Spending (Investment): Purchasing new capital goods such as new commercial real estate (buildings, factories, and stores) and equipment. This refers to goods used to produce goods in the future, not stocks, bonds, or financial assets.

    • Government Spending on Goods and Services: Actual spending on projects or goods, excluding transfer payments.

    • Exports: Selling goods outside of the country.

    • Imports: Buying goods from outside of the country.

Final vs. Intermediate Goods

  • Final Goods and Services: Output used directly for consumption, investment, government, and trade purposes. These are goods at the furthest stage of production at the end of a year.

  • Intermediate Goods: Output provided to other businesses at an intermediate stage of production, not for final users. These are excluded from GDP calculation.

  • Double Counting: Counting output more than once as it travels through the stages of production. This is a potential mistake to avoid when measuring GDP.

  • GDP Definition: GDP is the dollar value of all final goods and services produced in the economy in a year.

Examples of Macroeconomy Components

  • Milk for consumption from a Cow in Wisconsin: Yes, it is consumption.

  • Wood from a lumber mill that is going to be used to build a house: No, it is an intermediate good.

  • Stimulus check from government: No, it is a transfer.

  • Government building a new road: Yes, it is government spending.

  • Buying a car in the U.S. that is imported from Japan: Yes, it involves Imports and Consumption. When calculating GDP, these effects will cancel out.

  • Buying a commercial building to open a restaurant: It depends. Yes, if it is a new building; no, if it was previously owned by another company.

  • Cleaning your own bathroom: Yes, it is consumption, but it cannot be computed when calculating GDP.

Conceptual Understanding

  • Understanding aggregate demand, price levels, and real output can be challenging compared to microeconomics.

  • Price Levels: Think of it as an index. If prices of all goods increase, but wages don’t increase, the amount of stuff bought decreases.

The Aggregate Demand Curve (Continued)

  • The Aggregate Demand (AD) curve slopes downward, indicating that as the price level rises, the amount of total spending on domestic goods and services declines.

Shifts in Aggregate Demand

  • Components of aggregate demand: consumption spending, investment spending, government spending, spending on exports minus imports.

  • Given the price level and output:

    • A shift of the AD curve to the right means that at least one of its components increased, resulting in a greater amount of total spending at every price level.

    • A shift of the AD curve to the left means that at least one of its components decreased, resulting in a lesser amount of total spending at every price level.

  • Important detail: The components of aggregate demand are the only things that can shift the AD curve.

Examples: Consumers and Firms Affecting AD

  • When consumers feel more confident about the future economy, they tend to consume more, increasing AD.

  • If business confidence is high, firms tend to spend more on investment, expecting substantial future payoff, increasing AD.

  • Conversely, if consumer or business confidence drops, consumption and investment spending declines.

  • Consumer and business confidence are closely monitored due to their impact on AD.

Government Macroeconomic Policy Choices and AD

  • Higher government spending shifts AD to the right, while lower government spending shifts AD to the left.

  • Tax cuts for individuals tend to increase consumption demand, while tax increases diminish it.

  • Tax policy can also stimulate investment demand by offering lower tax rates for corporations or tax reductions that benefit specific kinds of investment.

  • During a recession, the U.S. often passes tax cuts to address high unemployment and business losses.