Shifts of the Aggregate Demand Curve

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.

Shifts of the Aggregate Demand Curve Panel (a) shows the effect of events that increase the quantity of aggregate output demanded at any given aggregate price level, such as improvements in business and consumer expectations or increased government spending. Such changes shift the aggregate demand curve to the right, from AD1 to AD2. Panel (b) shows the effect of events that decrease the quantity of aggregate output demanded at any given aggregate price level, such as a fall in wealth caused by a stock market decline. This shifts the aggregate demand curve leftward from AD1 to AD2.

A number of factors 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 spending, 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 below.

TABLE 12-1 Factors That Shift Aggregate Demand

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 spending rises; if they become more pessimistic, aggregate spending falls.

In fact, short-run economic forecasters pay careful attention to surveys of consumer and business sentiment. In particular, forecasters watch the Consumer Confidence Index, a monthly measure calculated by the Conference Board, and the Michigan Consumer Sentiment Index, a similar measure calculated by the University of Michigan.

PITFALLS

PITFALLS: CHANGES IN WEALTH: A MOVEMENT ALONG VERSUS A SHIFT OF THE AGGREGATE DEMAND CURVE

CHANGES IN WEALTH: A MOVEMENT ALONG VERSUS A SHIFT OF THE AGGREGATE DEMAND CURVE
Earlier we explained that one reason the AD curve is downward sloping is the wealth effect of a change in the aggregate price level: a higher aggregate price level reduces the purchasing power of households’ assets and leads to a fall in consumer spending, C. But we’ve just explained that changes in wealth lead to a shift of the AD curve. Aren’t those two explanations contradictory? Which one is it—does a change in wealth move the economy along the AD curve or does it shift the AD curve? The answer is both: it depends on the source of the change in wealth. A movement along the AD curve occurs when a change in the aggregate price level changes the purchasing power of consumers’ existing wealth (the real value of their assets). This is the wealth effect of a change in the aggregate price level—a change in the aggregate price level is the source of the change in wealth.

For example, a fall in the aggregate price level increases the purchasing power of consumers’ assets and leads to a movement down the AD curve. In contrast, a change in wealth independent of a change in the aggregate price level shifts the AD curve. For example, a rise in the stock market or a rise in real estate values leads to an increase in the real value of consumers’ assets at any given aggregate price level. In this case, the source of the change in wealth is a change in the values of assets without any change in the aggregate price level—that is, a change in asset values holding the prices of all final goods and services constant.

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 spending. 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 real estate values was a major factor depressing consumer spending during the 2007–2009 recession.

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’s part of the reason for the deep slump in residential investment spending that began in 2006. The housing boom of the previous few years had created an oversupply of houses: by spring 2009, the inventory of unsold houses on the market was equal to more than 14 months of sales, and prices of new homes had fallen more than 25% from their peak. This gave the construction industry little incentive to build even more homes.