3. INTRODUCTION
The aggregate demand curve shows the combinations price and output levels
at which the goods and the money markets are simultaneously in equilibrium.
In economics aggregate demand is the total demand for final goods and
services in the economy at a given time and price level.
AD = C+I+G+(X-M)
C= Consumption Spending
I = Investment Spending
G = Government Spending
(X-M) = difference between spending on imports and receipts from exports
(Balance of Payments)
Aggregate Demand –Key Variables
1. Consumption Expenditure- Tax rates, Incomes, Wage.
2. Investment Expenditure- Spending on inventory , Machinery.
3. Government Expenditure- Defense, foreign aid , education.
4. Import Spending- Goods & services bought from Abroad.
5. Export Earning- Goods & services sold to Abroad.
4. DERIVING THE AGGREGATE DEMAND CURVE
• This curve is derived from the IS-LM framework.
• If the given price level is P0 and the nominal stock of money is M, then
the real stock of money is (M/P0).
• The IS curve is denoted by IS.
• The economy is in equilibrium at point E, and the output and interest
rates are denoted by Y0 and i0 respectively. The initial price level is
represented by P0.
P
LM
1
(M/P )
E
i
1
i0
InterestRate
Y
E
I
L
M
I
Y
1
A
E
E
5. • When P is at P0 the goods and the money market are in equilibrium at an
income level of Y0.
• In the next figure, point E shows the income and price combination
(Y0
, P0
). If the price falls from P0
to P1
, the real stock of money in the
economy Increases to M/P1
(for the same level of nominal stock of
money M). This increase in the real stock of money will lead to a shift of
LM curve downwards to LM1
(M/P1
). The new equilibrium is at point E1
.
Thus when the price level is P1
, the goods market and the money market
are in equilibrium at an income level of Y1
. When the price level falls
form P0
to P1
, the income level rises from Y0
to Y1
and vice versa.
Therefore the aggregate demand curve will be downward sloping.
AGGREGATE DEMAND POLICIES
P
Price
Level
Y
Outputand
Spending
Y
1
P
0
E
1
i
1
6. Both the fiscal and monetary policy changes influence and cause shift in the AD
curve.
1. Fiscal Policy
2. Monetary Policy
Effect of Fiscal policy on AD curve
In the previous of figure 1, the initial LM and IS curves correspond to a given
nominal quantity of money and the price level P0. The economy is at
equilibrium at point E. The AD curve shifts to the right in case of fiscal
i0
Int
er
Y0
E
Income and Output
LM
(M/P
IS
Y
1
AD
E
E
1
P
1
Price Level
Y0
7. expansion and to the left in case of fiscal contraction. At the initial price level
there is a new equilibrium at point E1 with higher interest rates and higher level
of income and spending. Thus at initial level of prices P0, equilibrium income
and spending are higher. This is shown point E1 in the lower panel. E1 is the
new equilibrium point on the new AD curve. A similar exercise at other points
on the original demand curve would lead to a new aggregate demand curve
AD1.
Effect of monetary policy on AD curve
An increase in the nominal stock of money results in higher real money stock at
each level of prices and thus shifts the LM curve to LM1. The equilibrium level
of income rises from Y0 to Y1 at the initial price level P0 and the AD curve moves
Outp
ut
Y
IS
1
E
i
1
i0
I
Y0
E Inco
8. to the right in case the equilibrium level of income rises, which occurs due to
increase in the nominal stock of money.
Aggregate Demand Curve Shifts
1.Increase in income of consumer.
2.Increase in price of substitute goods.
3.Increase in no. of consumers.
1.Decrease in consumer income.
9. 2. Decrease in price of substitute goods.
3. Decrease in no. of consumer's.
DEMAND Curve downward sloping
The horizontal axis shows the total quantity of
domestic goods & services demanded.
The vertical axis shows the aggregate price level,
measured by the GDP deflator.
Income effect
Substitute effect
Law of diminishing marginal utility
Size of the consumers
10. The Equilibrium Price Level
AD represents money and goods market in
equilibrium.
AS represents price/output decisions of all
firms in ecomony.
P0 and Y0 correspond to equilibrium in the
goods market and the money market and a
set of price/output decisions on the part of
all the firms in the economy.
