Shifts to the left
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.
