Description                                  
In this presentation, the narrator describes the relationship between income and the overall price level in terms of aggregate demand. The narrator also explains how the aggregate demand curve is derived; the three reasons why the equilibrium GDP decreases as the price level increases; and the effect that monetary and fiscal policy have on aggregate demand. 

Narrator: 
The Keynesian cross is a useful tool in explaining how an economy can achieve equilibrium GDP. But, it has a serious shortcoming. It assumes that prices are constant. 

Narrator: 
What is needed is a more robust model that relates income to the overall price level and shows what happens when the price level changes. Such a relationship is aggregate demand. The aggregate demand curve is downward sloping and looks just like a regular demand curve, but it is fundamentally different. 

Narrator: 
Consider the Keynesian cross... the aggregate expenditure curve represents an assumption that prices are constant at a level of 120. If the price level were to rise to 130, consumption and thus, aggregate expenditure would decrease. This leads to a drop in equilibrium GDP. The aggregate demand curve is derived by plotting the relationship between the price level and equilibrium GDP. The curve shows that equilibrium GDP decreases as the price level increases. 

Narrator: 
There are three reasons for this. First, consumers hold some of their assets in the form of cash. If prices rise, consumers have less purchasing power. Therefore, they buy fewer goods and equilibrium GDP decreases. This is called the real balances effect because inflation has decreased the real value of their cash balances. 

Narrator: 
Reason number two is the interest rate effect. Not all purchases are made with cash. For so called big-ticket items like cars and homes, most people borrow money. When faced with inflation, banks will raise interest rates, which increases the cost of borrowing that money. Thus, when interest rates rise, people buy fewer goods and equilibrium GDP decreases. 

Narrator: 
The third reason equilibrium GDP falls with a rise in price level is the terms of trade effect. If the price level in the U.S. rises relative to other countries, U.S. consumers will find foreign goods to be relatively cheaper and will often substitute the foreign goods for domestic ones. Foreign consumers will also buy fewer U.S. goods. Both of these forces lead to a decrease in equilibrium GDP. 

Narrator: 
Now let's consider how changes in aggregate demand occur. Both fiscal and monetary policies can influence aggregate demand. At a given price level, if the government were to increase spending, then aggregate expenditures would increase. This new equilibrium point represents a higher GDP at the given price level. This point does not lie on the initial aggregate demand curve. In fact, the curve has actually shifted to the right or increased as a result of the increase in government spending. 

Narrator: 
Tax changes also shift the aggregate demand curve. For example, a tax increase would decrease aggregate demand because at a given price level, disposable income decreases, and therefore consumption and equilibrium GDP decrease. 

Narrator: 
In general, an expansionary fiscal policy will cause an increase in aggregate demand and a contractionary fiscal policy will cause a decrease in aggregate demand. When the Fed undertakes monetary policy, interest rates change. Increases in interest rates will cause firms to increase investment by purchasing plants and equipment or building up of inventories, thus aggregate expenditure decreases. This leads to a decrease in aggregate demand. So, an interest rate increase causes a decrease in aggregate demand. Conversely, if interest rates were to fall, investment would increase and so would aggregate demand. 

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