AP Macro Topic 3.

1
Aggregate Demand (AD)
Part 1 - Practice - For each of the following situations, identify the determinant (shifter) and indicate if
the aggregate demand (AD) would most likely increase, decrease, or not change.

Situation Determinant of AD Change in AD

1. Congress cuts personal income taxes by Consumption Increase

$20 million.

2. Interest rates increase causing a decrease Investment Decrease

in capital stock.

3. Consumer confidence declines and Consumption Decrease

people fear a recession.

4. Stock market collapses causing the loss Consumption Decrease

of millions of dollars of assets.

5. The price level increases by 5%. No Change No Change

6. Defense spending is increased due to Government Increase

military conflicts abroad.

7. The government raises taxes and Consumption & Decrease

cuts spending in attempt to balance its Government
budget.

8. Future business expectations are Investment Increase

predicting growth for most US industries.

9. Interest rates decrease from 5% to 2%. Investment and Increase

Consumption

10. Incomes increase for US trading Net exports Increase

partners Canada and China.

Part 2 - Draw It - Draw the effect on aggregate demand as a result of the following scenarios. Label the
axes and the aggregate demand curve and show the change using an arrow.
 Part 3 - Making Connections - Read the quote regarding the Great Recession and answer the
questions.

“...these events have...destroyed jobs, hamstrung economic growth and led to sharp declines in
the values of many homes and businesses. The best and most comprehensive solution is to find
ways to a stronger economy…only a strong economy will allow people who need jobs to find them. ”
- Ben
Bernanke, Chairman of the Federal Reserve (2012)

15. What most likely happened to aggregate demand in the US to cause the Great Recession? Use
specific words or phrases from the quote above to support your answer.

During the Great Recession, aggregate demand in the US experienced a significant decrease, and
this is clearly supported by several phrases from Bernanke's quote. The mention of "destroyed jobs"
indicates a severe reduction in employment, which led to decreased consumer spending power. The
phrase "hamstrung economic growth" directly points to a slowdown in overall economic activity. Most
importantly, the "sharp declines in the values of many homes and businesses" represents a massive
negative wealth effect - when people's assets lose value, they feel poorer and reduce their spending.
 All these factors combined to shift the aggregate demand curve significantly to the left, representing
a major contraction in overall spending and economic activity. The interconnected nature of these
effects created a downward spiral, where job losses led to reduced spending, which in turn caused
more business failures and further job losses.

16. The Federal Reserve has the power to manipulate interest rates. Do you think that Ben Bernanke
recommended higher interest rates or lower interest rates to create a “stronger economy”? Explain
your reasoning.

Ben Bernanke would most likely have recommended lower interest rates to create a "stronger
economy." This conclusion is based on several economic principles. Lower interest rates stimulate
both investment and consumption components of aggregate demand. When interest rates are
reduced, businesses find it cheaper to borrow money for investment in capital goods, expansion
projects, and new ventures. Similarly, consumers find it more affordable to make purchases using
credit and to take out mortgages for homes. This increased spending and investment helps create
the "stronger economy" Bernanke mentions as necessary for job creation. Given that the quote
emphasizes the need for job creation ("only a strong economy will allow people who need jobs to find
them"), lower interest rates would be the appropriate tool to stimulate economic activity and
employment through increased aggregate demand.

Part 4 - Stretch Your Thinking

17. The wealth effect, interest-rate effect, and exchange-rate effect all help explain why the
aggregate demand curve is downward sloping. Phyllis, a fellow student in your AP Macro class,
suggests that the substitution effect that you learned about in Unit 1 also explains why aggregate
demand curve is downward sloping. She reasons that since it explains why a market demand curve
is downward sloping, it must also be valid for aggregate demand. Explain why Phyllis is wrong.

Phyllis's reasoning about the substitution effect and aggregate demand is incorrect because she's
confusing microeconomic and macroeconomic concepts. The substitution effect explains individual
market demand curves by showing how consumers shift their purchases between different goods based
on relative prices. However, the aggregate demand curve represents something fundamentally different -
it shows the relationship between the overall price level and real GDP for the entire economy. When we
talk about price level changes in aggregate demand, there's no "substitute good" for the entire
economy's output. The downward slope of the AD curve is instead explained by the three effects
mentioned: the wealth effect (higher prices reduce real wealth and purchasing power), the interest-rate
effect (higher prices increase money demand and interest rates, reducing investment), and the
exchange-rate effect (higher prices affect international trade competitiveness). These are all
macroeconomic effects that operate on the economy as a whole, unlike the substitution effect which
operates at the individual market level. This is a classic example of the fallacy of composition - what's
true for a part (individual market) isn't necessarily true for the whole (entire economy).

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