The Great Depression, the great majority of economists agree, was the result of a massive negative, or adverse, demand shock. What does that mean? In Chapter 3 we explained that when economists talk about a fall in the demand for a particular good or service, they’re referring to a leftward shift of the demand curve. Similarly, when economists talk about a negative, or adverse, demand shock to the economy as a whole, they’re referring to a leftward shift of the aggregate demand curve, a curve that shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, firms, the government, and the rest of the world.

Figure 12-1 shows what the aggregate demand curve may have looked like in 1933, at the end of the 1929-1933 recession. The horizontal axis shows the total quantity of domestic goods and services demanded, measured in 2002 dollars. We use real GDP to measure aggregate output and will often use the two terms interchangeably. The vertical axis shows the aggregate price level, measured by the GDP deflator. With these variables on the axes, we can draw a curve, AD, showing how much aggregate output would have been demanded at any given aggregate price level. Since AD is meant to illustrate aggregate demand in 1933, one point on the curve corresponds to actual data for 1933, when the aggregate price level was 6.6 and the total quantity of domestic final goods and services purchased was $54.7 billion in 2002 dollars.

As drawn in Figure 12-1, the aggregate demand curve is downward sloping, indicating a negative relationship between the aggregate price level and the quantity of aggregate output demanded. A higher aggregate price level, other things equal, reduces the quantity of aggregate output demanded; a lower aggregate price level, other things equal, increases the quantity of aggregate output demanded. According to Figure 12-1, if the price level in 1933 had been 3.1 instead of 6.6, the total quantity of domestic final goods and services demanded would have been $80 billion in 2002 dollars instead of $54.7 billion.

The first key question about the aggregate demand curve is: why should the curve be downward sloping?

In Figure 12-1, the curve AD is downward sloping. But why? Recall the basic equation of national income accounting:

(12-1) GDP = C + I + G + X − IM

where C is consumer spending, I is investment spending, G is government purchases of goods and services, X is exports to other countries, and IM is imports. If we measure these variables in constant dollars—that is, in prices of a base year— then C + I + G + X − IM is the real quantity of domestically produced final goods and services demanded during a given period. G is decided by the government, but the other variables are largely from private-sector decisions. To understand why the aggregate demand curve slopes downward, we need to understand why a rise in the aggregate price level reduces C, I, and X − IM.

You might think that the downward slope of the aggregate demand curve is a natural consequence of the law of demand we defined back in Chapter 3. That is, since the demand curve for any one good is downward sloping, isn’t it natural that the demand curve for aggregate output is also downward sloping? This turns out, however, to be a misleading parallel. The demand curve for any individual good shows how the quantity demanded depends on the price of that good, holding the prices of other goods and services and income constant. The main reason the quantity of a good demanded falls when the price of that good rises—that is, the quantity of a good demanded falls as we move up the demand curve—is that people switch their consumption to other goods and services.

But when we consider movements up or down the aggregate demand curve, we’re considering a simultaneous change in the prices of all final goods and services. Furthermore, changes in the composition of goods and services in consumer spending aren’t relevant to the aggregate demand curve: if consumers decide to buy fewer clothes but more cars, this doesn’t necessarily change the total quantity of final goods and services they demand.

Why, then, does a rise in the aggregate price level lead to a fall in the quantity of all domestically produced final goods and services demanded? There are two main reasons: the wealth effect and the interest rate effect of a change in the aggregate price level.

The Wealth Effect An increase in the aggregate price level, other things equal, reduces the purchasing power of many assets. Consider, for example, someone who has $5000 in a bank account. If the aggregate price level were to rise by 25%, what used to cost $5000 would now cost $6250, and would no longer be affordable. And what used to cost $4000 would now cost $5000, so that the $5000 in the bank account would now buy only as much as $4000 would have bought previously. With the loss in purchasing power, the owner of that bank account would probably scale back his or her consumption plans. Millions of other people would respond the same way, leading to a fall in real spending on final goods and services, because a rise in the aggregate price level reduces the purchasing power of everyone’s bank account. Correspondingly, a fall in the aggregate price level increases the purchasing power of consumers’ assets and leads to more consumer demand. The wealth effect of a change in the aggregate price level is the effect on consumer spending caused by the effect of a change in the aggregate price level on the purchasing power of consumers’ assets. Because of the wealth effect, consumer spending, C, falls when the aggregate price level rises, leading to a downward-sloping aggregate demand curve.

The Interest Rate Effect Economists use the term money in its narrowest sense to refer to cash and bank deposits on which people can write cheques and do debit transactions. People and firms hold money because it reduces the cost and inconvenience of undertaking transactions. An increase in the aggregate price level, other things equal, reduces the purchasing power of a given amount of money holdings. To purchase the same basket of goods and services as before, people and firms now need to (and want to) hold more money. So, in response to an increase in the aggregate price level, the public tries to increase its money holdings, either by borrowing more or by selling assets such as bonds. This reduces the funds available for lending to other borrowers and drives interest rates up.

In Chapter 10 we learned that a rise in the interest rate reduces investment spending because it makes the cost of borrowing higher. It also reduces consumer spending because households save more of their disposable income. So a rise in the aggregate price level depresses investment spending, I, and consumer spending, C, owing to the rise in interest rates, which is in turn caused by the shrinking real purchasing power of money holdings. This effect is known as the interest rate effect of a change in the aggregate price level. This also leads to a downward-sloping aggregate demand curve.

We’ll have a lot more to say about money and interest rates in Chapter 15 on monetary policy. We’ll also see, in Chapter 19, which covers open-economy macroeconomics, that a higher interest rate indirectly tends to reduce exports (X) and increase imports (IM). The result, which is lower net exports (X − IM), further depresses aggregate expenditure on domestically produced final goods and services. For now, the important point is that the aggregate demand curve is downward sloping due to both the wealth effect and the interest rate effect of a change in the aggregate price level.

In the preceding chapter we introduced the income–expenditure model, which shows how the economy arrives at income–expenditure equilibrium. Now we’ve introduced the aggregate demand curve, which relates the overall demand for goods and services to the overall price level. How do these concepts fit together?

Recall that one of the assumptions of the income–expenditure model is that the aggregate price level is fixed. We now drop that assumption. We can still use the income–expenditure model, however, to ask what aggregate expenditure would be at any given aggregate price level, which is precisely what the aggregate demand curve shows. So the AD curve is actually derived from the income–expenditure model. Economists sometimes say that the income–expenditure model is “embedded” in the AD-AS model.

Figure 12-2 shows, once again, how income–expenditure equilibrium is determined. Real GDP is on the horizontal axis; real planned aggregate expenditure is on the vertical axis. Other things equal, real planned aggregate expenditure, equal to consumer spending plus planned investment spending, rises with real GDP. This is illustrated by the upward-sloping lines AE_Planned1 and AE_Planned2. Income–expenditure equilibrium, as we learned in Chapter 11, is at the point where the line representing real planned aggregate expenditure crosses the 45-degree line. For example, if AE_Planned1 is the relationship between real GDP and real planned aggregate expenditure, then income–expenditure equilibrium is at point E₁, corresponding to a level of real GDP equal to Y₁.

We’ve just seen, however, that changes in the aggregate price level change the level of real planned aggregate expenditure at any given level of real GDP. This means that when the aggregate price level changes, the AE_Planned curve shifts. For example, suppose that the aggregate price level falls. As a result of both the wealth effect and the interest rate effect, the fall in the aggregate price level will lead to higher real planned aggregate expenditure at any given level of real GDP. So the AE_Planned curve will shift up, as illustrated in Figure 12-2 by the shift from AE_Planned1 to AE_Planned2. The increase in real planned aggregate expenditure leads to the multiplier process that moves the income–expenditure equilibrium from point E₁ to point E₂, raising real GDP from Y₁ to Y₂.

Figure 12-3 shows how this result can be used to derive the aggregate demand curve. In Figure 12-3, we show a fall in the aggregate price level from P₁ to P₂. We saw in Figure 12-2 that a fall in the aggregate price level would lead to an upward shift of the AE_Planned curve and hence a rise in real GDP. You can see this same result in Figure 12-3 as a movement along the AD curve: as the aggregate price level falls, real GDP rises from Y₁ to Y₂.

So the aggregate demand curve doesn’t replace the income–expenditure model. Instead, it’s a way to summarize what the income–expenditure model says about the effects of changes in the aggregate price level.

In practice, economists often use the income–expenditure model to analyze short-run economic fluctuations, even though strictly speaking it should be seen as a component of a more complete model. In the short run, in particular, this is usually a reasonable shortcut.

In Chapter 3, where we introduced the analysis of supply and demand in the market for an individual good, we stressed the importance of the distinction between movements along the demand curve and shifts of the demand curve. The same distinction applies to the aggregate demand curve. Figure 12-1 shows a movement along the aggregate demand curve, a change in the aggregate quantity of goods and services demanded as the aggregate price level changes.

But there can also be shifts of the aggregate demand curve, changes in the quantity of goods and services demanded at any given price level, as shown in Figure 12-4. When we talk about an increase in aggregate demand, we mean a shift of the aggregate demand curve to the right, as shown in panel (a) by the shift from AD₁ to AD₂. A rightward shift occurs when the quantity of aggregate output demanded increases at any given aggregate price level. A decrease in aggregate demand means that the AD curve shifts to the left, as in panel (b). A leftward shift implies that the quantity of aggregate output demanded falls at any given aggregate price level.

When the aggregate demand curve shifts to the right, it is called a positive shift, since it usually has a positive impact on aggregate real income (it rises), employment (more jobs are created), and the unemployment rate (it decreases). Similarly, a shift to the left is called an adverse shift because it usually has a negative impact on aggregate real income (it decreases), employment (there are fewer jobs), and the unemployment rate (it increases). When the curve shifts unexpectedly, we refer to it as a shock. Positive AD shocks and adverse AD shocks help drive the business cycle, which refers to short-run fluctuations of real economic variables away from long-run (equilibrium) values.

A number of factors that are unrelated to inflation can shift the aggregate demand curve. Among the most important factors are changes in expectations, changes in wealth, and the size of the existing stock of physical capital. In addition, both fiscal and monetary policy can shift the aggregate demand curve. All five factors set the multiplier process in motion. By causing an initial rise or fall in real GDP, they change disposable income, which leads to additional changes in aggregate expenditure, which lead to further changes in real GDP, and so on. For an overview of factors that shift the aggregate demand curve, see Table 12-1.

Changes in Expectations As explained in Chapter 11, both consumer spending and planned investment spending depend in part on people’s expectations about the future. Consumers base their spending not only on the income they have now but also on the income they expect to have in the future. Firms base their planned investment spending not only on current conditions but also on the sales they expect to make in the future. As a result, changes in expectations can push consumer spending and planned investment spending up or down. If consumers and firms become more optimistic, aggregate expenditure rises (perhaps due to an increase in autonomous consumption and/or autonomous investment); if they become more pessimistic, aggregate spending falls (as the increased pessimism reduces autonomous consumption and/or autonomous investment). In fact, short-run economic forecasters pay careful attention to surveys of consumer and business sentiment. In particular, forecasters watch for the monthly Index of Consumer Confidence and the quarterly Index of Business Confidence, both from the Conference Board of Canada, and the quarterly Business Outlook Survey from the Bank of Canada. These indexes measure the level of optimism about the economic conditions by consumers and businesses respectively. An increase in the index means that agents are more optimistic about the future while a fall in the index signals a decrease in the level of optimism.

Changes in Wealth Consumer spending depends in part on the value of household assets. When the real value of these assets rises, the purchasing power they embody also rises, leading to an increase in aggregate expenditure. For example, in the 1990s there was a significant rise in the stock market that increased aggregate demand. And when the real value of household assets falls—for example, because of a stock market crash—the purchasing power they embody is reduced and aggregate demand also falls. The stock market crash of 1929 was a significant factor leading to the Great Depression. Similarly, a sharp decline in U.S. real estate values was a major factor in depressing consumer spending during the 2007-2008 U.S. financial crisis, which spread to Canada. In late 2008 and early 2009, Canadian consumer and business confidence declined as agents grew more fearful of the worsening worldwide economic climate. The Index of Consumer Confidence fell about 50% and the Index of Business Confidence fell about 30%. Consumers feared the U.S. slowdown would not only lead to job losses in Canada, but might bring falling house prices to Canada as well.

Size of the Existing Stock of Physical Capital Firms engage in planned investment spending to add to their stock of physical capital. Their incentive to spend depends in part on how much physical capital they already have: the more they have, the less they will feel a need to add more, other things equal. The same applies to other types of investment spending—for example, if a large number of houses have been built in recent years, this will depress the demand for new houses and as a result also tend to reduce residential investment spending. In fact, that in part explains why residential investment spending slumped by 13% in the fourth quarter of 2008. The housing boom of the previous few years had created an oversupply of houses: by the spring of 2009, the inventory of unsold houses on the market had risen even though housing starts were down significantly. In early 2009, Canadian resale home prices began to fall. This gave the construction industry little incentive to build even more homes at that time.

One of the key insights of macroeconomics is that the government can have a powerful influence on aggregate demand and that, in some circumstances, this influence can be used to improve economic performance.

The two main ways the government can influence the aggregate demand curve are through fiscal policy and monetary policy. We’ll briefly discuss their influence on aggregate demand, leaving a full-length discussion for upcoming chapters.

Fiscal Policy As we learned in Chapter 6, fiscal policy is the use of either government spending—government purchases of final goods and services and government transfers—or tax policy to stabilize the economy. In practice, governments often respond to recessions by increasing spending, cutting taxes, or both. They often respond to inflation by reducing spending or increasing taxes.

The effect of government purchases of final goods and services, G, on the aggregate demand curve is direct because government purchases are themselves a component of aggregate demand. So an increase in government purchases shifts the aggregate demand curve to the right and a decrease shifts it to the left. History’s most dramatic example of how increased government purchases affect aggregate demand was the effect of wartime government spending during World War II. Because of the war, real government purchases of goods and services surged 570%. This increase in purchases is usually credited with ending the Great Depression. Recent decades offer other examples of the effect of increased government spending. In the 1990s, Japan used large public works projects—such as government-financed construction of roads, bridges, and dams—in an effort to increase aggregate demand in the face of a slumping economy. Similarly, in 2009, to stimulate overall spending, federal and provincial governments in Canada began to spend more than $63 billion, mostly on infrastructure projects such as improving highways, bridges, public transportation, university and college buildings, and so on.

In contrast, changes in either tax rates or government transfers influence the economy indirectly through their effect on disposable income. A lower tax rate means that consumers get to keep more of what they earn, increasing their disposable income. An increase in government transfers also increases consumers’ disposable income. In either case, this increases consumer spending and shifts the aggregate demand curve to the right. A higher tax rate or a reduction in transfers reduces the amount of disposable income received by consumers. This reduces consumer spending and shifts the aggregate demand curve to the left.

Monetary Policy We opened this chapter by talking about the problems faced by the Bank of Canada, which controls monetary policy—the use of changes in the quantity of money or the interest rate to stabilize the economy. We’ve just discussed how a rise in the aggregate price level, by reducing the purchasing power of money holdings, causes a rise in the interest rate. That, in turn, reduces both investment spending and consumer spending.

But what happens if the quantity of money in the hands of households and firms changes? In modern economies, the quantity of money in circulation is largely determined by the decisions of a central bank created by the government. As we’ll learn in Chapter 14, the Bank of Canada, Canada’s central bank, is a special institution that is neither exactly part of the government nor exactly a private institution. When the central bank increases the quantity of money in circulation, households and firms have more money, which they are willing to lend out. The effect is to drive the interest rate down at any given aggregate price level, leading to higher investment spending and higher consumer spending. That is, increasing the quantity of money supplied shifts the aggregate demand curve to the right. Reducing the quantity of money supplied has the opposite effect: households and firms have less money holdings than before, leading them to borrow more and lend less. This raises the interest rate, reduces investment spending and consumer spending, and shifts the aggregate demand curve to the left.