Key points

  • The aggregate demand/aggregate supply model is a model that shows what determines total supply or total demand for the economy and how total demand and total supply interact at the macroeconomic level.
  • The aggregate demand curve, or AD curve, shifts to the right as the components of aggregate demand—consumption spending, investment spending, government spending, and spending on exports minus imports—rise. The AD curve will shift back to the left as these components fall.
  • AD components can change because of different personal choices—like those resulting from consumer or business confidence—or from policy choices like changes in government spending and taxes.
  • If the AD curve shifts to the right, then the equilibrium quantity of output and the price level will rise. If the AD curve shifts to the left, then the equilibrium quantity of output and the price level will fall.
  • Whether equilibrium output changes relatively more than the price level or whether the price level changes relatively more than output is determined by where the AD curve intersects with the aggregate supply curve, or AS curve.

Introduction

We learned earlier—in the aggregate demand and aggregate supply curves article—that aggregate demand is made up of four components: consumption spending, investment spending, government spending, and spending on exports minus imports.
Increasing any of these components shifts the AD curve to the right, leading to a greater real GDP and to upward pressure on the price level. Decreasing any of the components shifts the AD curve to the left, leading to a lower real GDP and a lower price level.
Whether these changes in output and price level are relatively large or relatively small, and how the change in equilibrium relates to potential GDP, depends on whether the shift in the AD curve happens in the relatively flat or relatively steep portion of the short-range aggregate supply, or SRAS, curve.
In this article, we'll discuss two broad categories that can cause AD curves to shift—changes in the behavior of consumers or firms and changes in government tax or spending policy.

How do changes by consumers and firms affect AD?

When consumers feel more confident about the future of the economy, they tend to consume more. If business confidence is high, then firms tend to spend more on investment, believing that the future payoff from that investment will be substantial. On the other hand, if consumer or business confidence drops, then consumption and investment spending decline.
Because a rise in confidence is associated with higher consumption and investment demand, it leads to an rightward shift in the AD curve. If you'll look at Diagram A, on the left below, you'll see that this shift right moves the equilibrium from start text, E, 0, end text to start text, E, 1, end text—a higher quantity of output and a higher price level.
Shifts in aggregate demand
 
Consumer and business confidence often reflect macroeconomic realities. For example, confidence is usually high when the economy is growing briskly and low during a recession. However, economic confidence can sometimes rise or fall due to factors that do not have a close connection to the immediate economy, like a risk of war, election results, foreign policy events, or a pessimistic prediction about the future by a prominent public figure.
US presidents, for example, must be careful in their public pronouncements about the economy. If a president makes pessimistic statements about the economy, they risk provoking a decline in confidence that reduces consumption and investment, shifting AD to the left and causing the recession that the president warned against in the first place. You can see what this scenario would look like graphically in Diagram B, on the right above. A shift of AD to the left moves the equilibrium from start text, E, 0, end text to start text, E, 1, end text, a lower quantity of output and a lower price level.

Government macroeconomic policy choices can shift AD.

Because the government has influence over several of the components of aggregate demand, it has the power to shift AD through its policy choices.
Take, for example, government spending—one component of AD. Higher government spending causes AD to shift to the right—see Diagram A, on the left above—while lower government spending will cause AD to shift to the left—see Diagram B, on the right above.
Tax policy can affect consumption and investment spending as well. Tax cuts for individuals will tend to increase consumption demand, while tax increases will tend to diminish it. Tax policy can also pump up investment demand by offering lower tax rates for corporations or tax reductions that benefit specific kinds of investment. Since both consumption and investment are components of aggregate demand, changing either will shift the AD curve as a whole.
During a recession, when unemployment is high and many businesses are suffering low profits or even losses, the US Congress often passes tax cuts. During the recession of 2001, for example, a tax cut was enacted into law. At such times, the political rhetoric often focuses on how people going through hard times need relief from taxes. The aggregate supply and aggregate demand framework, however, offers a complementary rationale.
Let's examine the situation graphically using the AD/AS model below. The original equilibrium during the recession is at point start text, E, 0, end text, relatively far from the full-employment level of output. The tax cut, by increasing consumption, shifts the AD curve to the right. At the new equilibrium, start text, E, 1, end text, real GDP rises and unemployment falls and—because in this diagram the economy has not yet reached its potential or full-employment level of GDP—any rise in the price level remains muted.
 
Other policy tools can shift the aggregate demand curve as well. For example, the Federal Reserve can affect interest rates and the availability of credit. Higher interest rates tend to discourage borrowing and thus reduce both household spending on big-ticket items like houses and cars and investment spending by businesses. On the other hand, lower interest rates will stimulate consumption and investment demand. Interest rates can also affect exchange rates, which in turn will have effects on the export and import components of aggregate demand.

Summary

  • The aggregate demand/aggregate supply model is a model that shows what determines total supply or total demand for the economy and how total demand and total supply interact at the macroeconomic level.
  • The aggregate demand curve shifts to the right as the components of aggregate demand—consumption spending, investment spending, government spending, and spending on exports minus imports—rise. The AD curve will shift back to the left as these components fall.
  • AD components can change because of different personal choices—like those resulting from consumer or business confidence—or from policy choices like changes in government spending and taxes.
  • If the AD curve shifts to the right, then the equilibrium quantity of output and the price level will rise. If the AD curve shifts to the left, then the equilibrium quantity of output and the price level will fall.
  • Whether equilibrium output changes relatively more than the price level or whether the price level changes relatively more than output is determined by where the AD curve intersects with the AS curve.