Aggregate Demand

There are many actions that will cause the aggregate demand curve to shift. When the aggregate demand curve shifts to the left, the total quantity of goods and services demanded at any given price level falls. This can be thought of as the economy contracting.

To understand what causes the economy to contract, let's start with the basic equation for the demand curve. Recall that the price level is not directly in the equation for aggregate demand. Rather, it is implicit in each of the terms in the equation. We know that aggregate demand is comprised of C(Y - T) + I(r) + G + NX(e) = Y. Thus, a decrease in any one of these terms will lead to a shift in the aggregate demand curve to the left.

The first term that will lead to a shift in the aggregate demand curve is C(Y - T). This term states that consumption is a function of disposable income. If disposable income decreases, consumption will also decrease. There are many ways that consumption can decrease. An increase in taxes would have this effect. Similarly, a decrease in income--holding taxes stable--would also have this effect. Finally, a decrease in the marginal propensity to consume or an increase in the savings rate would also decrease consumption.

The second term that will lead to a shift in the aggregate demand curve is I(r). This term states that investment is a function of the interest rate. If the interest rate increases, investment falls as the cost of investment rises. There are a number of ways that investment can fall. If the interest rate rises, say due to contractionary monetary or fiscal policy, investment will fall. Similarly, in the short run, expansionary fiscal policy will also cause investment to fall as crowding out occurs. Another interesting cause of a fall in investment is an exogenous decrease in investment spending. This occurs when firms simply decide to invest less without regard for the interest rate.

The term variable that will lead to a shift in the aggregate demand curve is G. This term captures the whole of government spending. The only way that government spending is changed is though fiscal policy. Recall that the budgetary debate is an ongoing political battlefield. Thus, government spending tends to change regularly. When government spending decreases, regardless of tax policy, aggregate demand decrease, thus shifting to the left.

The fourth term that will lead to a shift in the aggregate demand curve is NX(e). This term means that net exports, defined as exports less imports, is a function of the real exchange rate. As the real exchange rate rises, the dollar becomes stronger, causing imports to rise and exports to fall. Thus, policies that raise the real exchange rate though the interest rate will cause net exports to fall and the aggregate demand curve to shift left. Again, an exogenous decrease in the demand for exported goods or an exogenous increase in the demand for imported goods will also cause the aggregate demand curve to shift left as net exports fall. An example of this type of exogenous shift would be a change in tastes or preferences.

The aggregate demand curve also can shift right as the economy expands. When the aggregate demand curve shifts right, the quantity of output demanded for a given price level rises. Therefore, a shift of the aggregate demand curve to the right represents an economic expansion. A shift of the aggregate demand curve to the right is simply effected by the opposite conditions that cause it to shift to the left.

The aggregate demand curve alone is useful. It tells how the price level and output or income are related. It shows the general effects of changes in many economic variables and the relationship between price level and output or income. But there are limits to its usefulness. It cannot show where the economy currently sits. Similarly, it cannot predict the effects of an economic policy upon the economy.

In the next section, we will look at aggregate supply. This counterpart to aggregate demand completes the AS-AD model of the macroeconomy. That is, the aggregate supply and aggregate demand model of the economy is based on the total demand for goods and services and the total supply of goods and services. Once you are comfortable with the reasons for the downward sloping aggregate demand curve and with the ways and directions that the aggregate demand curve shifts, you are prepared to move on to the aggregate supply curve.