Aggregate Demand

1
Aggregate Demand SupplyPart I Demand

2
Bringing Prices Forward

• In neither Keynesian Cross nor IS - LM model are
  prices explicit and obvious
• Yet, inflation was viewed as central problem by
  end of 1960s and more so after Oil Shock '73-74
• So, theory was revised to highlight price
  inflation
• This was done through "aggregate supply demand
  model"

3
Aggregate Demand

• Can we derive a relationship between aggregate
  demand and output like Y f(P) from what we have
  developed so far?
• Yes, because prices are included in analysis of
  money demand, i.e., Md f(i, Y, P)
• We postulate that dMd/dP gt 0, that is to say as
  prices rise, so does the demand for money
• because more money is needed to buy the same
  amount of higher priced stuff

4
?P shifts Md

• Assume an increase in prices, Md shifts

i
Md' f(P2)
Md f(P1)
Money, M
5
Effects of Price Change

• Shift in Md raises interest
• Rise in interest will reduce investment
• Rise in interest will reduce consumption
• Rise in prices will reduce real wealth and thus
  consumption

6
?P raises i

• With no change in Ms, interest rate rises

Ms
i
i2
i1
Md'
Md
Money, M
7
?i lowers I

• ? interest rate lowers level of investment

i2
i1
MEC
I1
I2
8
? I, lowers Y

• Reduction in I, lowers Y

I, S
S
I1
I2
Y
Y1
Y2
9
Aggregate Demand Curve

• ?P ? Md? ? ?i ? ?I ? ?Y or , dY/dP lt 0

P
P2
P1
AD
Y
Y2
Y1
10
Consumption Interest

• By the time the ASAD curves were developed,
  consumer credit was well advanced, so we also
  know that changes in interest rates affect
  consumption expenditures (on durables)
• Therefore just as I f(i),
• So, too, does C f(i) as well as f(Y)
• So price changes that raise i will lower C as
  well as I

11
Real Balance Effect

• In modern consumption theory, it is generally
  assumed that consumption is a function not only
  of Y and of i, but also of real wealth
• In otherwords the greater your real wealth, the
  more you are likely to spend
• Changes in prices change real wealth, price
  increases reduce it, price reductions raise it,
  and therefore have an impact on consumption and
  thus on Y.

12
Effects of Fiscal Policy - I

• ? G, or ?T or ?t will shift AD right

P
P2
P1
AD'
AD
Y
Y2
Y1
13
Effects of Fiscal Policy - II

• ? G, or ?T or ?t will shift AD left

P
P2
P1
AD
AD'
Y
Y2
Y1
14
Effects of Monetary Policy - I

• ? Ms will?i ?I,??Y to shift AD right

P
P2
P1
AD'
AD
Y
Y2
Y1
15
Effects of Monetary Policy - II

• ?Ms will?i ?I, ?C, ??Y to shift AD left

P
P2
P1
AD'
AD
Y
Y2
Y1
16
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