Aggregate Demand

Why is AD downward sloping?

1. Real-Balance Effect:

·         higher price levels reduce the purchasing power of money 

·         This decreases the quantity of expenditures

·         Lower price level increase purchasing power and increase expenditures (i.e. Balance in your bank is $50,000 but inflation erodes purchasing power, you're likely to reduce your spending)

2.    Interest Rate Effect:

·         when price level increases, lenders need to charge higher interest rates to get REAL return on their loans 

·         Higher interest rates discourage consumer spending and business investment (i.e. Increase in price leads to increase 5 to 25%. Less Liberty to take out a loan to improve business)

3.    Foreign Trade Effect:

·         when US price level increases, foreign buyers purchase fewer US goods and Americans buy more foreign goods 

·         Exports fall and imports rise causing real GDP to fall [X_n decrease](I.e. If price triples in US, Canada will no longer buy US goods causing quantity demanded to fall) 

Shifters of AD 

GDP= C+Ig+G+Xn

There are 2 parts to a shift in AD

1.    a change in C, Ig, G, and/ or Xn

2.    A multiplier effect that produces a greater change when the original change in the 4 components

• Increase= AD shifts right
• Decrease= AD shifts left