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.
We can express aggregate demand using the following formula where C, I, G, X, and M represent consumption spending, investment spending, government spending, spending on exports, and spending on imports, respectively:
A, D, equals, C, plus, I, plus, G, plus, X, minus, M
But why is there a minus sign in front of imports? Does this mean that more imports will result in a lower level of aggregate demand?
Think about it this way—when an American buys a foreign product, it gets counted along with all the other consumption. But, the income generated does not go to American producers; it goes to producers in another country. It would be wrong to count this as part of domestic demand. To account for this situation, imports added in consumption, C, are subtracted back out in the M term of the equation above.
Because of the way in which the demand equation is written, it is easy to make the mistake of thinking that imports are bad for the economy. Just keep in mind that every negative number in the M term has a corresponding positive number in the C, I, or G term, and they always cancel out.
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.
The University of Michigan publishes a survey of consumer confidence and constructs an index of consumer confidence each month. According to the index, consumer confidence averaged around 90 prior to the Great Recession, and then it fell to below 60 in late 2008—the lowest it had been since 1980. Since then, confidence has climbed from a 2011 low of 55.8 back to a level in the low 80s, which is considered close to a healthy state.
One measure of business confidence is published by the Organisation for Economic Co-operation and Development, OECD: the business tendency surveys. Business opinion survey data are collected for 21 countries on future selling prices and employment, among other elements of the business climate. After sharply declining during the Great Recession, the OECD measure has risen above zero again—the indicator dips below zero when business outlook is weaker than usual—and is back to long-term averages.
In reality, neither of these survey measures is very precise. They can however, suggest when confidence is rising or falling, as well as when it is relatively high or low compared to the past.
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 E, 0 to E, 1—a higher quantity of output and a higher price level.
Shifts in aggregate demand
The two graphs show how aggregate demand shifts. The graph on the left shows aggregate demand shifting to the right toward the vertical potential GDP line. The graph on the right shows aggregate demand shifting to the left away from the vertical GDP line.
Image credit: Figure 1 in "Shifts in Aggregate Demand" by OpenStaxCollege, CC BY 4.0
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 E, 0 to E, 1, 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 E, 0, 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, E, 1, 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.
One of the most fundamental divisions in American politics over the last few decades has been between those who believe that the government should cut taxes substantially and those who disagree.
Ronald Reagan rode into the presidency in 1980 partly because of his promise, soon carried out, to enact a substantial tax cut. George Bush lost his bid for reelection against Bill Clinton in 1992 partly because he had broken his 1988 promise: “Read my lips! No new taxes!” In the 2000 presidential election, both George W. Bush and Al Gore advocated substantial tax cuts, and Bush succeeded in pushing a package of tax cuts through Congress early in 2001. Disputes over tax cuts often ignite at the state and local level as well.
What side are economists on? Do they support broad tax cuts or oppose them? The answer, unsatisfying to zealots on both sides, is that it depends. One issue is whether the tax cuts are accompanied by equally large government spending cuts. Economists have differing opinions on how large government spending should be and what programs might be cut back.
A second issue, more relevant to the discussion in this chapter, concerns how close the economy is to the full-employment level of output. In a recession, when the intersection of the AD and SRAS curves is far below the full-employment level, tax cuts can make sense as a way of shifting AD to the right. However, when the economy is already doing extremely well, tax cuts may shift AD so far to the right as to generate inflationary pressures, with little gain to GDP.
With the AD/AS framework in mind, many economists might readily believe that the Reagan tax cuts of 1981, which took effect just after two serious recessions, were a beneficial economic policy. Similarly, the Bush tax cuts of 2001 and the Obama tax cuts of 2009 were enacted during recessions. However, some of the same economists who favor tax cuts in time of recession would be much more dubious about identical tax cuts at a time the economy is performing well and cyclical unemployment is low.
Recession and full employment in the AD/AS model
The graph shows an example of an aggregate demand shift. The higher of the two aggregate demand curves is closer to the vertical potential GDP line and hence represents an economy with a low unemployment. In contrast, the lower aggregate demand curve is much farther from the potential GDP line and hence represents an economy that may be struggling with a recession.
Image credit: Figure 2 in "Shifts in Aggregate Demand" by OpenStaxCollege, CC BY 4.0
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.

Self-check questions

How would a dramatic increase in the value of the stock market shift the AD curve? What effect would the shift have on the equilibrium level of GDP and the price level?
An increase in the value of the stock market would make individuals feel wealthier and thus more confident about their economic situation. This would likely cause an increase in consumer confidence leading to an increase in consumer spending, shifting the AD curve to the right. The result would be an increase in the equilibrium level of GDP and an increase in the price level.
Suppose Mexico, one of our largest trading partners and purchaser of a large quantity of our exports, goes into a recession. Use the AD/AS model to determine the likely impact on our equilibrium GDP and price level.
Since imports depend on GDP, if Mexico goes into recession, its GDP declines and so do its imports. This decline in our exports can be shown as a leftward shift in AD, leading to a decrease in our GDP and price level.
A policymaker claims that tax cuts led the economy out of a recession. Can we use the AD/AS diagram to show this?
Tax cuts increase consumer and investment spending, depending on where the tax cuts are targeted. This would shift AD to the right. If the tax cuts occurred when the economy was in recession—and GDP was less than potential—the tax cuts would increase GDP and “lead the economy out of recession.”
Many financial analysts and economists eagerly await reports on the home price index and consumer confidence index. What would be the effects of negative reports on both of these? What about positive reports?
A negative report on home prices would make consumers feel like the value of their homes—which for most Americans is a major portion of their wealth—has declined. A negative report on consumer confidence would make consumers feel pessimistic about the future. Both of these would likely reduce consumer spending, shifting AD to the left, reducing GDP and the price level.
A positive report on the home price index or consumer confidence would do the opposite.

Review questions

  • Name some factors that could cause AD to shift, and explain whether they would shift AD to the right or to the left.
  • Would a shift of AD to the right tend to make the equilibrium quantity and price level higher or lower? What about a shift of AD to the left?

Critical thinking questions

  • If households decided to save a larger portion of their income, what effect would this have on the output, employment, and price level in the short run? What about the long run?
  • If firms became more optimistic about the future of the economy and, at the same time, innovation in 3-D printing made most workers more productive, what would the combined effect on output, employment, and the price-level be?
  • If the US Congress cut taxes at the same time that businesses became more pessimistic about the economy, what would the combined effect on output, the price level, and employment be, based on the AD/AS diagram?

Attribution

This article is a modified derivative of "Shifts in Aggregate Demand" by OpenStaxCollege, CC BY 4.0.
The modified article is licensed under a CC BY-NC-SA 4.0 license.