Shifts in the Aggregate Demand Curve
We have already covered what the AD curve represents and what it looks like.
Now let’s learn how AD curve shifts and what causes these shifts.
Demand-side policies are used to shift aggregate demand to fit the government’s needs.
Specifically, there are the fiscal policy and the monetary policy. Below is a brief chart on
what these policies involve.
Fiscal Policy
Monetary Policy






Government spending
Taxes
Open market Operations
Discount rate
Reserve Requirement rate
Interest rate
Fiscal policy by the government is used to either increase or decrease aggregate demand.
For example, a government can increase its spending; this would increase AD, in turn,
increasing GDP (vice versa). This would go under an expansionary policy, which would
correct a budget deficit. Meanwhile, an increase in taxes would leave consumers with
less disposable income, which would decrease AD. This fiscal policy would be a
contractionary policy, mainly used for budget surplus
Monetary policy mainly is used through adjustment of the interest rate and open market
operations to alter the money supply that would correspond to the nation’s economic
state. An expansionary monetary policy involves decreasing interest rates, so that people
are not compelled to put their money in a bank, and thus keeping the money supply
increasing. Also, selling treasury bonds (OMOs) would increase the money supply
circulating within the nation, increasing AD. However, a contractionary policy entails
reducing the size of the money supply by increasing the different rates (ie discount rate,
interest rate, and reserve requirement rate) and buying OMOs, taking money out of the
economy, reducing AD.
Contractionary Policy
PL
Expansionary Policy
AS
PL
AS
AD’ AD
Real GDP
AD AD’
Real GDP
Shifts in the Aggregate Supply Curve
In order to shift the AS curve, supply-side policies would have to be used. In
contrast to Keynesian belief in demand-side economics, supply-siders believe that all our
economic problems can be corrected in the long run through gradually increasing money
supply (MS). This can be done with an expansionary fiscal policy, especially decreasing
taxes, which will bring about freer trade, and hence, increased AS. This is portrayed in
Figure 1 (The Laffer curve) in relation to government revenue. As tax rat increases, govt
revenue increases, but then at a certain point, govt revenue will fall when taxes are too
high.
Figure 1
Govt Revenue
0
T
1
Tax rate
There is a catch: aim these taxes to those with a high income, so that their tax savings can
be put back into investment, which would cause factories to be more productive, and the
nation has an increased AS. Another way that supply-side economics can be implemented
is by reducing regulations, so that there will be more of the products, thus increasing AS.
Below is the associated graph.
PL
LRAS
AS
LRAS2
AD
Q1
AS
AD
Q2
real GDP
Strengths and Weaknesses
The strengths and weakness of the demand-side policy and the supply-side policy
are shown in the chart below.
Demand-side Policy
Supply-Side Policy
Strengths
-Reduce unemployment
-MORE!
Weaknesses
-Fluctuations
-No consideration to longterm
-Long run economic gr
owth
- Increase in productivity
lower inflation
- Reduce Unemployment
- Increasing Govt tax
Revenues
-Long run stability
-No taking into account of
AD
-does not think of Short run
growth
-
Multiplier
The multiplier is the additional shift in aggregate demand each dollar spent can
have. The Multiplier Effect is the additional shift in aggregate demand brought about
when expansionary fiscal policy is implemented by the government.
A simple example of this effect is increased government spending. If the
government decides to spend another 50 million dollars on buildings and roads in
Atlanta, that money represents a shift in aggregate demand for the service (construction.)
These workers are paid by their employers to do their job, and thus more people have
more money (the increased demand will be met with higher wages or more jobs in order
to supply enough workers). This increase in the amount of money held by consumers
will, in turn, lead them to spend more money. When they spend more money than they
would have previously, demand shifts out again. This second shift is the additional shift
in aggregate demand brought about because the government spent 50 million dollars.
In order to calculate the multiplier’s effect, one necessary variable is the Marginal
Propensity to Consume (MPC) or the fraction of income a household will spend. If the
MPC is ¾ (or .75 or 75%) it represents that the households will spend approximately
three quarters of their income (or seventy five cents of every dollar they earn). Through
calculations involving infinite geometric series, the formula is:
_________1_________
(1 – MPC)
So, if MPC is .75, then the total multiplier is 4. (1 divided by .25).
The Accelerator
The accelerator effect is often a prediction of future growth based on the past
growth. In general, it is based on the desired and current level of capital (since capital
allows firms to produce more and thus has a similar effect on GDP as does the multiplier
effect.) A formula to calculate the accelerator is the net investment (I) equals the
coefficient of adjustment (A) times desired capital (D) minus the current level of capital
(C). So:
I= A * (D – C)
While the multiplier is caused by increased spending, the accelerator is caused by
increased production, which is the key difference. The increased capital goods causes
more production and thus economic growth, which shift aggregate demand out.
Multiplier is an increased shift in aggregate demand caused by increased spending,
usually by the government.
Crowding Out
While the Multiplier works to increase the total amount of aggregate demand
caused by an increase in spending (by government or otherwise), it is not the only effect
caused by this increased demand by the government. Working in the opposite direction,
crowding out is the offset in aggregate demand resulting from expansionary fiscal policy
raising interest rates and reducing investment spending. Essentially, the government
spends money on goods that prevents other companies from buying them. The way this
works. Essentially, households that wish to buy goods using that extra money have to
keep it in a liquid form, and so the demand for money increases. So:
Interest
Rate
I2
Price
Level
MD2
AD2
I1
AD3
AD1
MD1
Q. of Money
Q. of Output
The shift from AD1 to AD2 is because of the increased government spending and
multiplier effect. But the increased need for money causes the interest rate to rise and
money demand increases. This increased interest rate deters potential borrower like
businesses since they will have to return more interest. This decreases the aggregate
demand, thus the shift from AD2 to AD3. While the aggregate demand shifts out still, it
doesn’t shift out as far as if there was no crowding out.
THE MINI-IA
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aMmsL7BPn6.M
This article, “Egypt Inflation Easing Boosts Chance of Rate Cut”, talks about the
potential action that Egypt will take to correct its economy, due to the drop in global
commodity prices. As the article suggests, Egypt would implement a form of
expansionary demand-side policy. In this case, the central bank of Egypt will be most
likely to cut interest rates, the rate in percentage of money paid by the borrower.
Implementing an expansionary policy would mean that Egypt’s government
wants to increase economic growth, which is understandable due to the decreasing
benchmark inflation rate. Decreasing the interest rate would, in effect, lower the amount
of investment done by consumers in banks, as interest rates are an incentive of putting
money in a bank. This, in turn, would increase the money supply, compared to what it is
normally without the change in interest rate. Shown in Figure 1, increased money supply
would shift aggregate demand to the right, since people now have more money to spend
on goods and services. Thus, economic growth occurs, if only in the short run. Thus,
decreasing interest rates was a good thing to do, since it fulfilled Egypt’s government’s
goal.
Figure 1
PL
AS
AD’
AD
Real GDP