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## Macroeconomics

### Course: Macroeconomics>Unit 3

Lesson 6: Changes in the AD-AS model in the short run

# Shifts in aggregate demand

## 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
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 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.
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?
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.
A policymaker claims that tax cuts led the economy out of a recession. Can we use the AD/AS diagram to show this?
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?

## 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?

## Want to join the conversation?

• Pl guide how and from where we can find the answers of critical thinking questions
• * 1.)* 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?

*In the Short Run...*
-If households save more, they are spending less. Household consumption would decrease which would shift the Aggregate demand curve to the left. This shift will cause a new ad/as equilibrium. * If the AD curve shifts to the left, then the equilibrium quantity of output and the price level will fall.*

Also, with this shift, employment would decrease due to a less demand for output.
• Does anyone know where I can find the answers of critical thinking questions
• There are no answers. You have to come up with them on your own and/or ask smart people to tell you the answers.
• I challenge anyone who reads this to answer the very last question
• 3. 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?

- Tax cuts will increase consumption spending and business investment spending. If businesses are pessimistic and not increasing investment spending with this new incentive, then the increase in consumption spending will decrease any effects a decrease in business investment spending would have had. Effectively, the tax cut would keep the aggregate demand curve in it's current position and ad/as equilibrium would not change.
Therefore, Price level, output and employment would all remain the same.
• What about the MPC does this affect Aggregate Demand? because in one of the practice questions, the MPC is an incorrect answer. Even though we spent all that time learning multipliers and how they effect the Real GDP much more than you'd think. But no, apparently more income and more spending does not result in higher produce demanded. Fix your question Khan Academy, or if I am wrong, then at least explain it properly.
• how to know if a tax will shift AD or AS? In case of AD, a tax cut will increase AD-> AD shifts right. In case of AS, a tax cut will reduce cost of production -> AS increase --> AS shifts right.
• Want to double check with a question:

Assume the Australian economy is initially in a long run equilibrium, with real GDP equal to $1.5 trillion. Suppose, now, that there is a global stock market boom -- which enhances real wealth significantly, shifting aggregate demand (AD) to the right, and increasing real output, in the short run, by$60 billion. Assume LRAS does not shift over time.
If neither the government nor the reserve bank change their policies in response to this shock, then, ceteris paribus, in the long run:

1. The economy would stay stuck, with GDP at \$1.56 trillion.

2. The economy would recede because AD would automatically move back.

3. The economy would return to its initial equilibrium because the SRAS would move to the right.

5. None of the above.

WHICH ONE IS IT? THANK YOU!
(1 vote)
• I think the first situation is going to occur as the LRAS curve remains the same, whereas the AD curve shifts to the right from the position of equilibrium with LRAS. As it was stated in the article, the changes in AD when the economy is near its potential GDP will just put pressure on prices causing higher inflation. Thus, economy will face higher inflation with no possible growth of output (as potencial gdp is already reached) causing stagflation.
(1 vote)
• "Name some factors that could cause AD to shift, and explain whether they would shift AD to the right or to the left." Would it be right to give the following factors? Can anyone see other important factors I might have forgotten?

If we consider that: real GDP = C + I + G + NX (consumption + investment + government spending + net exports)

Factors causing AD to shift to the right:
- Tax cuts: making consumers more confident --> C rises and so does real GDP
- Tax benefits for companies investing --> I rises and so does real GDP
- Spendings on new road infrastructures --> G rises and so does real GDP
- New trade agreement with a new partner --> NX rise and so does real GDP

Factors causing AD to shift to the left:
- Austerity policy by the government --> reduces G and real GDP
- Having a trade partner going into recession --> NX decrease and so does real GDP

Thanks for the help!
(1 vote)
• Change in consumer level of confidence in the future of economy might fit as well
(1 vote)
• What will happen to the AD curve when there is an increase in money demand due to credit card fraud (excess of demand for money in respect to liquidity available)?

My intuition:

This shock increases interest rates (you have to pay people more to let go of their money), which will bring investments down (a loan cost more) and output.

So the AD will shift to the left.

Is this correct?
(1 vote)
• if the government wants to increase its spending to turn on the economy, where will that money come from if they don't increase tax or cut their spending in military or sth like that. but wouldn't an increase in tax will shift the AD curve to the left and bring the opposite outcome?
(1 vote)
• The government borrows the money from other economies or from the central banks or from the people of the economy via bonds etc..
Tax and government spending( i.e the G of the AD) are the tools of the Fiscal policy.
In order to bring back the economy to levels of potential GDP either from the inflationary gap(GDP above potential GDP situation) or the recessionary gaps (GDP below potential GDP situation), govt employs these tools.
An increase in Tax cuts and a decrease in the G, (usually employed in an Inflationary gap) discourage Consumption and Investment Components and AD decreases which will shift the AD curve to left bringing down the levels of GDP.
And the opposite is done in case of a recessionary gap.
(1 vote)
• "confidence is usually high when the economy is growing briskly and low during a recession"

Does the passage mean "expansion" instead?
(1 vote)