Shifts and movements in aggregate demand
Aggregate demand
Aggregate demand is the summation of all the agents in an economy that demand scarce resources. Demand is generated when economic agents spend income, including:
Spending by consumers (C) on consumer goods, by firms on capital goods (I), by the government on public and merit goods (G) and by overseas consumers and firms on a country's exports, less what an economy demands from overseas firms (X-M).
The aggregate demand equation is expressed as:
AD = C + I + G + (X-M)
The basic model
The basic model to explain and understand aggregate demand measures planned demand against the general price level. From this model, we can explain the two fundamental ways aggregate demand (or its individual components) can change:
- Through a direct change in the price level, assuming 'other determinants' remain constant - when this happens, there is a movement along the existing aggregate demand curve, and:
- By a change in 'other determinants', assuming the price level remains constant - when this happens, the positions of the aggregate demand curve will shift.
Movements along the AD curve
Movements along an AD curve simply reflect how current aggregate demand responds to changes in the price level.
It is noted that there are at least three factors to consider when the price level changes:
The purchasing power of monetary balances changes
When the price level rises (as in the diagram, from P to P1, and point e to e1) - as in the diagram below - the value of consumer holdings of cash, current bank accounts, savings, and other accounts falls. A rise in the price level erodes the value of these balances.
Assuming no compensating increase in money balances, the real value of these holdings falls – in other words, less can be purchased. The response of households is to cut back on spending. Conversely, a fall in the price level increases these real balances.
The interest rate effect
A rise in the general price level will reduce the value of money balances held in the economy, and assuming individuals, households and firms wish to maintain their purchases, they will be encouraged to borrow to replenish their balances.
This increase in borrowing will raise interest rates, which in turn will reduce spending across the economy.
The trade effect
A rise in the general price level will increase the price of a country’s exports and reduce the price of imports. This encourages domestic households and firms in country X to switch to relatively cheaper imports from country Y, and encourages overseas households and firms in country Y to switch away from more expensive exports from country X. The combined effect is to reduce aggregate demand.
When we combine these effects, we can see that, at a higher price level (at P1) aggregate demand contracts from e to e1, and at a lower price level (at P2), aggregate demand extends from e to e2.
Shifts in the AD curve
If we hold the price level constant, changes in the underlying determinants of aggregate demand, such as consumer spending, consumer confidence, investment, government spending, and net exports, will shift the position of the AD curve.
- Increases in consumer spending
- Decreases in savings
- Increases in investment spending
- Increases in government spending
- Reductions in direct taxes
- Increases in the money supply
- Increase in net exports
Causes of shifts to the right:
- Decreases in consumer spending
- Increases in savings
- Decreases in investment spending
- Decreases in government spending
- Increases in direct taxes
- Decreases in the money supply
- Decreases in net exports
