Aggregate Demand/Aggregate Supply Model
Aggregate Demand
Shifts in Aggregate Demand
Page 1 of 2
We are building a model of the macroeconomy, and our goal is to be able to predict business cycles and explain how
the economy will respond to changes in the environment. We have started with this aggregate demand curve, which
is kind of the main axis of the model we are building. The aggregate demand curve shows how total spending in the
economy is related to the aggregate price level. The aggregate price level influences spending through three
channels: First of all, rising prices shrink the real wealth of consumers and leave them to purchase less. Next, rising
prices increase the demand for money, pushing up interest rates and leading businesses to spend less. Finally, rising
prices cause our goods and our economy to be uncompetitive so that foreigners buy goods from other countries
shrinking net exports. The effect is that when prices rise, total spending falls and that means equilibrant income and
the economy, equilibrium spending, is less. That is why the aggregate demand curve slops downwards.
Now, the next question is: what would cause this curve to shift? A shift in the aggregate demand curve means that
there is more demand for goods and services in our economy at every price level. That means that, for any given
price level, people want to buy more stuff, and so factories respond by producing more. Let us ask the question then:
what would cause the aggregate demand curve to shift outward from this original curve AD0 to this new curve AD1?
On AD1, the total economy spending is greater at any given price level. Here is the question you need to answer:
what would cause people to spend more money if the price level did not change? We know that rising price levels
have the effect of shrinking total spending, but what would cause people to spend more at any given price level?
The first answer is an increase in autonomous spending. Autonomous means stuff that is by itself, unto itself, not
caused by something else. If consumers decided that they just wanted to spend more money for the heck of it, or
were feeling rich or confident about the future of the economy, then an increase in of consumer spending at every
price level would shift this outwards. More GDP, because factories have to produce more to keep up with increased
consumer demand.
The second thing could be an increase in autonomous investment spending. If businesses are feeling confident, they
may decide to spend more on factories, plant and equipment. If that is the case, at any given price level, we have a
larger aggregate demand and businesses have to produce more to satisfy that. The same happens with foreigners.
An increase in autonomous net exports comes about whenever foreigners decide they want more of our countries’
goods at every price level. That is the first thing that shifts out the aggregate demand curve, an increase in
autonomous spending from any of these components.
The second set of things that can increase aggregate demand are related to policy variables. Let me list them in
order. The first of the policy variables is government spending. If the government decides that it wants to spend
more, that is that there is an increased amount of government spending on goods and services, that adds directly to
aggregate demand at every price level. If the government starts building more roads and bridges, and spending
money on schools and things like that, this increased government spending increases the aggregate demand on the
economy, so businesses have to respond to produce the stuff that the government wants. That is one policy variable.
It is autonomous. The government can increase its spending or decrease its spending any time that it wants, but
when the government increases spending, we have an outward shift in the aggregate demand.
Another component that can shift the curve that is related to policy is taxes. Now, taxes have the opposite effect
because when taxes go up, people have less disposable income therefore, they are inclined to spend less. When
taxes fall, it is like giving extra income to consumers and usually consumers will spend a big chunk of it and that
increases aggregate demand at any price level. If the government wants to shift out the aggregate demand curve, if
the government wants to increase the aggregate demand, the government has tow policy tools to use: government
spending and taxes. An increase in government spending shifts the curve out, and a reduction in taxes shifts the
aggregate demand curve out.
The final policy variable that can shift out the aggregate demand curve is a change in the money supply. If the money
supply increases, then the interest rates are going to fall because there will be excess supply of money at the original
interest rate. The bidding mechanism pushes down the interest rate, and businesses respond by doing more
business spending at any given price level. An increase in money supply shifts out the aggregate demand curve
because of its direct effect on interest rates.
Aggregate Demand/Aggregate Supply Model
Aggregate Demand
Shifts in Aggregate Demand
Page 2 of 2
So there you have it; that is what can shift the aggregate demand curve outwards. To shift the aggregate demand
curves inwards, just reverse all of these stories. Decrease autonomous spending, reduce government spending, raise
taxes or shrink the money supply. The outwards and inwards shift of the aggregate demand curve can happen
naturally because of changes in the behavior of the big spenders in the economy or it can happen by choice. A policy
shift can move this curve. We will see later why the government may want to change its spending or why the fed may
want change the money supply in order to calm the business cycle or stimulate the economy. First, we need to
expand our model by adding an aggregate supply curve. Then we can put supply and demand together and we can
find an equilibrium price level for the economy and an equilibrium level of real gross domestic product.