The Aggregate Demand Curve

1
The Aggregate Demand Curve

• AD defined as
• C planned I G X M
• AD AE - unplanned changes in inventories
• The AD curve plots the relationship between
  planned AE (planned GDP) and aggregate prices (P,
  or the CPI).

2
The AD curve is downward-sloping because

• International Substitution Effect
• Inter-temporal Substitution Effect
• Real Wealth Effect

3
Shifts in AD

• AD shifts because of things that are not on the
  axis
• These are exogenous changes in AD
• Examples include changes in r, expected future
  income, exchange rates, government spending,
  foreign savings, foreign MFP, foreign business
  cycles, and taxes.

4
Shifts in AD

• Any exogenous shift is made larger if household
  consumption is sensitive to temporary changes in
  disposable income
• If mpcgt0 then things that shift AD also cause
  endogenous changes in AD
• This magnifying effect due to endogenous changes
  in AD is known as the AE multiplier or
  multiplier effect.

5
The AE multiplier

• Any shift in AD is equal to the exogenous change
  times the AE multiplier
• Shifts in AD are larger if mpc is large
• Shifts in AD are larger if mpm is small
• If everyone is rational and there are no credit
  constraints, then mpc mpm0 and the AE
  multiplier is equal to 1

6
The Aggregate Supply Curve

• GDP Aggregate Supply
• The AS curve plots a relationship between GDP and
  Aggregate Prices (P)
• Simple way to determine this is to hold MFP and
  K constant and ask
• What happens to P as L increases?
• Tells us what happens to P as GDP increases

7
Using the labor market to derive the AS curve
(relate GDP to P)

• As L up GDP up
• Assume diminishing returns
• As L up mpl down
• Assume perfect competition
• mpl w/p
• mpl down therefore w/p down
• Holding w constant, P up as mpl falls

8
The AS curve
9
AS and Long-Run AS

• L is at L in equilibrium (long-run)
• There is no long-run relationship between GDP and
  P because there is no long-run relationship
  between L and P
• In long run, wages adjust to any change in P and
  we return to L
• In long run, wages adjust to any change in P and
  we return to GDP
• GDP is trend or potential GDP
• Graphically, GDP is known as LRAS

10
Goods market equilibrium
P
GDP