Investment Spending
Sometimes investment spending is confused with investing in stocks and bonds, or “financial assets.” To an economist,
investmentis when firms purchase factors of production to facilitate their supply. When investment spending declines,
it shifts the aggregate demand curve to the left; when investment spending increases, it shifts the curve to the right.
Investment spending is determined by two factors:
■ Real interest rates:Interest is the price of money. As interest rates rise, fewer firms will invest because it will
become too costly to borrow money.
■ Expected returns:If firms expect high returns from their purchases of capital, they will be more likely to consume
more, thereby shifting the aggregate demand curve to the right.Government Spending
When the government decides to spend more on the economy, the aggregate demand curve shifts to the right. This hap-
pens because the revenue that the government spends increases employment and expands businesses. With more jobs,
people have more money, therefore increasing aggregate demand. However, if the government decreases spending, the
aggregate demand curve shifts to the left.
Exports
When U.S. and foreign consumers increase spending on U.S. exports and decrease spending on imports, this translates
into an increase in aggregate demand. The aggregate demand curve thus shifts to the right. On the other hand, the aggre-
gate demand curve shifts to the left if U.S. and foreign consumers buy more imported products. The change in exports is
caused by three factors: the price level, the level of income for foreigners, and the strength of the dollar relative to other
currencies.
Aggregate Supply
Aggregate supplyrepresents the combined domestic output that firms will produce at every price level. According to
the law of supply, the higher the price level, the more output produced by firms; the lower the price level, the less out-
put produced; thus a positive relationship exists between price level and output.
The aggregate supply curve has three ranges that illustrate the effect on production costs as GDP grows or contracts:
■ Range 1 (horizontal range):Typically represents a low level of employment, implying that the economy is in either
a depression or a recession. The productive capabilities of the economy (machines, labor, and raw materials) are
unused. The economy is operating below its productive capacity; therefore, it can employ unused resources with-
out creating an increase in the price level.
■ Range 2 (intermediate range):In this stage, real output is expanding due to a rise in the price level. This rise in
the price level is allowing the economy to expand production and increase employment. The economy is made
up of many product and factor markets; some of these markets do not reach full employment when the economy
reaches full employment. It is possible to have a market or an industry operating below full employment when
the aggregate economy is considered to be operating at full employment. Once the full employment GDP has been
reached, additional increases in the price level may yield increased output for a short time. This is possible because
firms may extend work hours for labor, individuals may take on second jobs, and raw materials may be used more
efficiently. In range 2, the economy reaches full employment, the price level rises, and output is increased.
■ Range 3 (vertical range):At the beginning of this stage, the economy reaches its full capacity. Any change in
the price level will no longer increase production. Resources are being fully employed; therefore, any increase
in demand will yield a higher price level (inflation).Figure 4-4 illustrates the three ranges in which aggregate supply can move. From point A to point B, there is high un-
employment with no increase in the price level. Between these points, output can increase without changing the price
Aggregate Expenditures, Aggregate Supply and Aggregate Demand Models