Shifts in the Aggregate Demand Curve

Graph Shifts in the Aggregate Demand Curve

The first graph represents a shift of the aggregate demand curve to the left, moving from AD1 to AD2, and the second graph represents a shift of the aggregate demand curve to the right, also moving from AD1 to AD2. Note that when the aggregate demand curve shifts, the level of aggregate output demanded at each price level changes. If the shift is to the right, aggregate demand increases at each price level, and if it is to the left, it decreases.

Factors Causing Shifts in the Aggregate Demand Curve

Let us remember that aggregate demand in an economy is divided into the following components:

When we graph the aggregate demand curve, all other factors besides the price level and total production of goods and services are held constant. When any of these other factors change, the aggregate demand curve shifts. We can classify the possible factors that may shift the aggregate demand curve depending on the component of aggregate demand to which they belong: consumption, investment, government spending, or net exports.

Shifts Resulting from Changes in Consumption

There are shifts that arise from changes in people's consumption habits. Any events that change the amount that people want to consume at each price level will shift the aggregate demand curve. Some factors that can change how much people want to consume include the concern for saving. When the concern for saving increases, the curve shifts to the left; when the concern for saving decreases, the curve shifts to the right. Tax burden also plays a role; when the tax burden increases, the aggregate demand curve shifts to the left, and when it decreases, it shifts to the right, among many other factors that can affect consumption.

Shifts Resulting from Changes in Investment

The aggregate demand curve also shifts as a consequence of changes in investment. Any events that generate a change in the amount that firms want to invest at each price level cause a shift in the aggregate demand curve. Some of these events may include future outlooks; with a positive outlook, firms are willing to invest more, and the curve shifts to the right. The opposite occurs with negative outlooks. Taxes, including negative taxes or subsidies, and the money supply also affect this; with a lower money supply, interest rates tend to increase, and vice versa. The interest rate can stimulate or discourage investment.

Shifts Resulting from Changes in Government Spending

The aggregate demand curve is also affected by changes in government spending, and thus, this can also shift the curve. Economic policy can shift the aggregate demand curve through government spending. The economy can be stimulated through the purchase of goods and services by the government or by an increase in public investment, or conversely, it can be discouraged.

Shifts Resulting from Changes in Net Exports

Net exports can also shift the aggregate demand curve. This occurs when an event changes net exports at each price level. These events can include a decrease or increase in the demand for domestic goods and services from abroad, and the effects of speculation on the exchange rate. When wealth is being brought into the country, the currency appreciates, and when wealth is being taken out, the currency depreciates. In the case of currency appreciation, the aggregate demand curve shifts to the left, and in the case of depreciation, it shifts to the right.

In summary, the aggregate demand curve can shift due to multiple factors, but we can group them by the spending component that is most affected: household consumption spending, business investment spending, government spending, or net exports. Ultimately, any event that affects any of these four components of spending, other than the price level, will result in a shift of the aggregate demand curve.

Shifts of the Aggregate Demand Curve According to the Quantity Theory of Money

When graphing the aggregate demand curve based on the quantity theory of money, it is plotted for a fixed money supply. That is, the aggregate demand curve in this case tells us all the possible combinations of P and Y for a given value of M. If there is a change in the money supply by the central bank, all the possible combinations of P and Y change, and the curve shifts toward those new combinations.

In the previous graph, the case is considered where the central bank increases the money supply. The equation MV=PY states that an increase in the money supply, with the velocity of money (V) constant, results in an increase in the nominal value of production (PY). Now, for each price level, the output is higher, and for each level of output, the price level is higher. Consequently, the aggregate demand curve shifts to the right, moving from AD1 to AD2 in the graph.

Now we can consider the case where the central bank reduces the money supply (M). A reduction in the money supply in the equation MV=PY, while keeping the velocity of money (V) constant, results in an equal proportionate reduction in the nominal value of output (PY). Therefore, now for each price level, the quantity of output is lower, and conversely, for each level of output, the price level decreases. Consequently, the aggregate demand curve shifts to the left, moving from AD1 to AD2 in the graph.

It should be noted that this is a simple explanation given by the quantitative equation of money, where it is assumed that the velocity of circulation of money is constant. The reality is more complex; even if the money supply remains constant, the aggregate demand curve can shift if some event causes a change in the speed at which money circulates.