The Equation of Aggregate Demand

The Equation of Aggregate Demand
We now combine the four components of aggregate demand to get an expression for total
aggregate demand, denoted :
where we have written disposable income as output, , less taxes, . This equation
shows that aggregate demand for home output can be written as a function of the real
exchange rate, disposable income, investment demand, and government spending:
We now want to see how aggregate demand depends on the real exchange rate and domestic
GNP given the level of taxes, , investment demand, , and government purchases, .
The Real Exchange Rate and Aggregate Demand
A rise in makes domestic goods and services cheaper relative to foreign goods and
services and shifts both domestic and foreign spending from foreign goods to domestic
goods. As a result, CA rises (as assumed in the previous section) and aggregate demand, ,
therefore goes up. A real depreciation of the home currency raises aggregate demand for
home output, other things equal; a real appreciation lowers aggregate demand for home
output.
Real Income and Aggregate Demand
The effect of domestic real income on aggregate demand is slightly more complicated. If
taxes are fixed at a given level, a rise in represents an equal rise in disposable income .
While this rise in raises consumption, it worsens the current account by raising home
spending on foreign imports. The first of these effects raises aggregate demand, but the second
lowers it. Since the increase in consumption is divided between higher spending on home
products and higher spending on foreign imports, however, the first effect (the effect of
disposable income on total consumption) is greater than the second (the effect of disposable
income on import spending alone). Therefore, a rise in domestic real income raises aggregate
demand for home output, other things equal, and a fall in domestic real income lowers aggregate
demand for home output.
Yd
Y Yd
D
EP*/P
T I G
D = D(EP*/P, Y - T, I, G).
Yd Y T
D = C(Y - T) + I + G + CA(EP*/P,Y - T),
D
Yd
Yd
426 PART THREE Exchange Rates and Open-Economy Macroeconomics
Aggregate
demand, D
Output (real income), Y
Aggregate demand function,
D(EP*/P, Y – T, I, G)
45°
Figure 17-1
Aggregate Demand as a Function
of Output
Aggregate demand is a function
of the real exchange rate ,
disposable income ,
investment demand (I), and
government spending (G). If all
other factors remain unchanged,
a rise in output (real income), Y,
increases aggregate demand.
Because the increase in aggregate
demand is less than the increase
in output, the slope of the aggregate
demand function is less than 1
(as indicated by its position within
the 45-degree angle).
(Y - T)
(EP*/P)
Figure 17-1 shows the relation between aggregate demand and real income for fixed values
of the real exchange rate, taxes, investment demand, and government spending. As rises,
consumption rises by a fraction of the increase in income. Part of this increase in consumption,
moreover, goes into import spending. The effect of an increase in on the aggregate demand
for home output is therefore smaller than the accompanying rise in consumption demand,
which is smaller, in turn, than the increase in . We show this in Figure 17-1 by drawing the
aggregate demand schedule with a slope less than 1. (The schedule intersects the vertical axis
above the origin because investment, government, and foreign demand would make aggregate
demand greater than zero, even in the hypothetical case of zero domestic output.)