Aggregate demand is the relationship between GDP and the price level. When only the price level changes, GDP changes and we move along the Aggregate Demand curve. The total amount of goods and services, adjusted for inflation, is real GDP. This text is referring to Real GDP whenever GDP is mentioned. As the price level increases, GDP decreases. As the price level decreases, GDP increases. Therefore, Aggregate Demand is downward sloping (see graph). For aggregate demand, this happens because of the wealth effect, the interest rate effect, and the international substitution effect. Wealth Effect The wealth effect means that as price levels change, the purchasing power of people s income and wealth change. When the price level goes up, they cannot purchase as many goods with the same amount of income and wealth and GDP decreases. On the other hand, when the price level goes down, they 1
are able to buy more goods and services. Therefore, GDP increases as the price level goes down. Interest Rate Effect When the price level goes up, goods and services are more expensive. To buy the same amounts of goods, people need more cash. As a result, people s demand for money increases, driving up interest rates. When interest rates increase, businesses borrow less for investment and investment spending goes down. Because investment is one component of GDP, GDP goes down and you move along the AD curve. If interest rates decrease, this is reversed and you would move down along the AD curve as GDP increases. The curve itself, aggregate demand, does not move, but GDP does change as the price level changes. You just move to a different point on the aggregate demand curve. International Substitution Effect Another effect, the international substitution effect, can also cause GDP to change when the price level changes. For instance, when the price level increases, U.S. goods become more expensive to foreigners, and foreign goods become less expensive. As a result, U.S. exports go down and imports increase as consumers buy more of the cheaper foreign goods. Net exports, the difference between exports and imports, decrease. Because net exports (X M) is a component of GDP, GDP also decreases. When the price level decreases, this sequence is reversed. U.S. exports are less expensive to foreigners, and the imports that Americans buy from foreigners become more expensive in the United States. Exports increase, imports decrease, and net exports increase. Because net exports (X M) are also a component of GDP, GDP increases. Shifts in Aggregate Demand So far, you have only examined how changes in the price level cause GDP to change, and you have only been able to move along a stationary aggregate 2
demand curve. However, there are other variables that effect aggregate demand and aggregate supply as well. Assuming that the price level is held constant, a change in any of the components of GDP, consumption, investment, government spending, taxes, monetary policy, or net exports may cause a shift in aggregate demand. Aggregate Supply For a complete model, need to also examine the production side of the economy. Aggregate supply is the relationship between the total quantity of goods and services that all of the firms in the economy produce and the price level. In the short run, as the price level increases, firms are induced to produce more. Note that you assume wages, capital, natural resources, and technology are held constant. 3
When the aggregate supply curve shifts, it is known that at any given price level, businesses are willing to produce more because unit costs are lower. A shift may be caused by exchange rate shocks; for example, if there is a large change in the real value of a country s currency, or by changes in business taxes. Inflationary expectations may also create a shift in aggregate supply to the left, resulting in lower equilibrium GDP. 4
Aggregate Supply and Demand The open economy equilibrium is the point at which the aggregate supply and aggregate demand curves intersect. 5
When AD or AS shift, the equilibrium price level and equilibrium GDP also change. 6
An increase in aggregate demand increases equilibrium GDP and increases the price level. 7
An increase in aggregate supply increases equilibrium GDP and decreases the price level. AD/AS and Trade Many economic conditions are subject to and reflective of government policy. Export policy is an important part of government policy, and trade makes up much of the gross domestic product (GDP) in countries that have open economies. Aggregate supply and demand can affect exports and imports. Exports are affected by the level of income of the foreign country and by the income elasticity of demand for exports. 8
Income elasticity shows how much a country s exports were affected by an increase or decrease in foreign income. For example, for every dollar increase in income, exports increase a dollar. Exports are also affected when domestic currency appreciates or depreciates. When currency appreciates, exports fall, and when currency depreciates, exports rise. This is an inverse relationship. The extent of how much it goes up or down depends on the price elasticity. The real exchange rate also plays an important role in determining a country s imports, which is a function of domestic income and income elasticity of demand for imports. As currency appreciates, it is more valuable in terms of other currencies. Other currencies are worth less. This makes imports less expensive, and imports go up. When a currency depreciates, foreign goods are more expensive. Imports go down. How much imports go up or down in relation to the exchange rate is the price elasticity of demand for imports. Smaller changes in the exchange rate should have a small effect on imports. Large changes in rates should have a large effect on imports. 9