Shifts in Aggregate Demand
Economics: IB Diploma, topic 2.2.4
Shifts in the Aggregate Demand Curve
The AD can shift because of changes in its components; consumption, investment, government spending and net exports. Changes in the price level will cause a movement along the AD curve, rather than a shift.
Shifts in AD
- AD shifts because of a change in any of consumption, investment, government spending, exports or imports. This can be caused by changes in behavior or changes in government policy.
- E.g changes in business confidence or taxation. If firms are more confident, they are more likely to borrow to finance investment. This shifts AD right and AD is now higher at every price level.
Changes in consumer behavior
- 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.
- Conversely, if consumer or business confidence drops, then consumption and investment spending decline.
Government policy affecting AD
- Government spending is one component of AD. Thus, higher government spending will cause AD to shift to the right, while lower government spending will cause AD to shift to the left.
- Tax policy can affect consumption and investment spending, too. 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.
Demand 'shocks'
- A demand-side shock is anything (positive or negative) that causes AD to change.
- Examples of a negative shock could be an interest rate rise, a collapse in the housing market, etc.
- As well as a fall in real GDP, this could have a knock-on effect on confidence, leading to further falls in activity.
- The multiplier and accelerator effects could magnify the impact of any initial negative shock.
- Keynesians may suggest government intervention would be required at this point.
Test yourself on Shifts in Aggregate Demand
Which of the following would lead to an increase in aggregate demand?
What is the nature of the relationship between Aggregate Demand and the average price level?