Macroeconomics/Aggregate Demand

After discussing the AE model, we will discuss aggregate demand and aggregate supply model (AD-AS model), in which AD curve is based on the concept of AE.

Definition. (AD-AS model) AD-AS model is a model that explains SR fluctations in $P$ and $Y$ .

To build the AD-AS model, we need to build and examine the AD curve and AS curves(there are two types of AS curves, namely short run aggregate supply (SRAS) curve and long run aggregate supply (LRAS) curve). In this chapter, we will examine the AD curve. In the next chapter about aggregate supply, we will build and examine the SRAS and LRAS curves.

We should recall how AD is built using the relationship between AE and $P$ , in the chapter about AE. The following section (one section with its subsections) is a brief review about that, and it can be safely skipped if you are familiar with it .

Brief review: components of Aggregate Demand

Aggregate Demand or Aggregate Expenditure (abbreviated to AD and AE respectively) is essentially the demand curve for goods and services for a whole economy. There are determinable parts, known as components of aggregate demand, which the next few pages will explain in more detail.

The formula for finding $Y$ is as follows: $Y=C+I+G+NX$

Consumption (C)

This is the expenditure by consumer on goods and services, including both durable and non-durable goods but not including saving. While values vary widely between economies, 'C' usually accounts for 40-60% of GDP. Because of this, high or low consumer confidence, and consequently high or low consumer spending can change the course in an economy.

Investment (I)

Strictly known as Gross Domestic Fixed Capital Formation, this is the money spent by firms (not the government or consumers) on capital investment i.e. new machinery and factories. There is some argument as to whether human capital (training) should be included. Investment also includes stocks and goods and services not yet completed; for example, car firms will likely have many machines part-built or stored at any one time. Since they cannot be included in consumption since they have not been purchased, stores must be included in I.

Investment makes up approximately 10% of GDP in most economies, and governments are often keen to increase this value, as investment helps to increase the possible output of economy (strictly LRAS or the PPF).

Government purchases (G)

Strictly known as General Government Final Consumption, it is the expenditure by the government, not including transfer payments (e.g. social security, welfare benefits since they are simply moving money around the economy). Governments usually spend on public and merit goods. These are microeconomic terms. A public good is one that is provided to everybody and cannot be exclusive by its nature (think street lighting), whilst a merit good is one that is under-supplied and under-demanded as consumers do not appreciate all the benefits, because some of those benefits do not directly apply to the buyer (think environmentally friendly vehicles).

Changes in government spending as a method of controlling the economy is known as fiscal policy. It will be discussed later.

Net exports (NX)

Exports are a positive figure on Aggregate Demand as overseas customers purchase goods and services produced here. Imports, on the other hand, are not produced here, though they are consumed here. For imports, money is leaving the economy, while for exports, money is entering the economy.

Movements of AD curve

Movements along AD curve vs. shifting AD curve

In this section, we will consider movements of AD curve. There are two ways of moving the AD curve, namely movements along the AD curve and shifting the AD curve.

The movements along the AD curve is caused by $\Delta P$ , not caused by a change in component of $Y$ (i.e. not caused by $\Delta C,I,G$ or $NX$ )^[1]. We have discussed the movement along the AD curve when we explain why AD curve is downward sloping (how $\Delta P$ (only) affects $Y$ ) .

Illustration of $\nwarrow$ movement along AD curve:

    P (GDP deflator, 2022=100)
    | 
    | \
105 |  *
 ^  |   \   AD
 |  |    \
100 |     *
    |      \
    |----------- Y (trillion 2022 USD)
      20->22

On the other hand, the shift of AD curve is caused by changing in some component of AD (i.e. component of $Y$ : $C,I,G$ or $NX$ ) ^[2] Under the parallel (we may assume this for simplicity) shift of AD curve, for each $P$ , we have the same $\uparrow$ (for $\nearrow$ shift) or $\downarrow$ (for $\swarrow$ shift) in $Y$ .

Illustration of $\nearrow$ shift of AD curve, from $AD_{0}$ to $AD_{1}$ :

    P (GDP deflator, 2022=100)
    | 
    | AD_0  AD_1
    |  \     \
    |   \     \   
    |    \     \
100 |-----\-----\
    |     |\   | \
    |--------------- Y (trillion 2022 USD)
          20   30

Shifting the AD Curve

Indeed, we can use some policies to shift AD curve, e.g. monetary policy ^[3] and fiscal policy ^[4]. We will discuss these two policies in later chapters.

We will introduce several important factors that shift AD curve in the following proposition, by affecting the component(s) of AD ( $C,I,G$ or $NX$ )

Proposition. (Factors shifting AD curve)

(positively related) households' expectations of their future incomes ( $inc^{e}$ ), or firms'expectation of the future profitability of investment spending ( $\Pi _{I}^{e}$ ) $\uparrow (\downarrow )\Rightarrow AD\nearrow (\swarrow )$
(negatively related) (nominal ( $i$ ) or real ( $r$ ) ) interest rates ^[5], or $T$ $\uparrow (\downarrow )\Rightarrow AD\swarrow (\nearrow )$
$\uparrow {\text{ in }}Y_{\text{domestic}}>(<)\uparrow {\text{ in }}Y_{\text{foreign}}\Rightarrow AD\swarrow (\nearrow )$

Proof. We have similar explanations in the chapter about AE, since essentially shifting AD curve $\Leftrightarrow$ $\Delta Y=\Delta AE$ for each $P$ , so change in factors affecting AE can also shift AD.

$inc^{e}\uparrow (\downarrow )\Rightarrow \Rightarrow C\;\&\;I({\text{new houses}})\uparrow (\downarrow )\Rightarrow AD\nearrow (\swarrow )$
$\Pi _{I}^{e}\uparrow (\downarrow )\Rightarrow I\uparrow (\downarrow )\Rightarrow AD\nearrow (\swarrow )$
$r\uparrow \Rightarrow I\downarrow (\uparrow )\Rightarrow AD\swarrow (\nearrow )$
$T\uparrow (\downarrow )\Rightarrow C\downarrow (\uparrow )({\text{for personal taxes}}){\text{ OR }}I\downarrow (\uparrow )({\text{for business taxes}})\Rightarrow AD\swarrow (\nearrow )$
$\uparrow {\text{ in }}Y_{\text{domestic}}>(<)\uparrow {\text{ in }}Y_{\text{foreign}}\Rightarrow X\downarrow \&\;M\uparrow \Rightarrow AD\swarrow (\nearrow )$

$\Box$

↑ ceteris paribus, it implies that the relationship between $P$ and $Y=C+I+G+NX$ , i.e. the AD curve itself, does not change, since $C,I,G$ and $NX$ do not change. So, there are only movements along the same AD curve instructed by $\Delta P$
↑ ceteris paribus, it implies that the relationship between $P$ and $Y=C+I+G+NX$ , i.e. the AD curve itself, changes, since $C,I,G$ or $NX$ changes, and so there is change (i.e. shift) in AD curve
↑ it affects the nominal interest rate ( $i$ ) by changing the money supply ( $M^{s}$ )
↑ it shifts the AD curve directly by changing $G$ and taxes ( $T$ )
↑ since $i=r+{\text{inflation rate}}(\pi )$ , ceteris paribus ( ${\overline {\pi }}$ particularly), $i\uparrow (\downarrow )\Leftrightarrow r\uparrow (\downarrow )$ , so $i\uparrow (\downarrow ){\text{ OR }}r\uparrow (\downarrow )$ has the same effect

[1] teris paribus, it implies that the relationship between $P$ and $Y=C+I+G+NX$ , i.e. the AD curve itself, does not change, since $C,I,G$ and $NX$ do not change. So, there are only movements along the same AD curve instructed by $\Delta P$

[2] teris paribus, it implies that the relationship between $P$ and $Y=C+I+G+NX$ , i.e. the AD curve itself, changes, since $C,I,G$ or $NX$ changes, and so there is change (i.e. shift) in AD curve

[3] t affects the nominal interest rate ( $i$ ) by changing the money supply ( $M^{s}$ )

[4] t shifts the AD curve directly by changing $G$ and taxes ( $T$ )

[5] since $i=r+{\text{inflation rate}}(\pi )$ , ceteris paribus ( ${\overline {\pi }}$ particularly), $i\uparrow (\downarrow )\Leftrightarrow r\uparrow (\downarrow )$ , so $i\uparrow (\downarrow ){\text{ OR }}r\uparrow (\downarrow )$ has the same effect

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