Shifts of the Aggregate Demand Curve
- The aggregate demand (AD) curve shows the total spending on goods and services in an economy at different price levels.
- When the determinants of AD change, the curve shifts, reflecting an increase or decrease in overall economic activity.
Movements along the AD curveoccur due to changes in the price level, while shiftsare caused by changes in the determinants of AD.
Determinants of Aggregate Demand
The components of aggregate demand are:
- Consumption (C)
- Investment (I)
- Government Spending (G)
- Net Exports (X - M)
Any change in these components will cause the AD curve to shift.
Consumption (C)
Consumption is the total spending by households on goods and services. Factors affecting consumption include:
1. Consumer Confidence
- When consumers feel optimistic about the economy, they spend more, shifting AD to the right.
- Conversely, pessimism leads to reduced spending, shifting AD to the left.
During a recession, rising unemployment may cause consumers to cut back on spending, shifting the AD curve leftward.
2. Interest Rates
- Higher interest rates increase the cost of borrowing and encourage saving, reducing consumption and shifting AD leftward.
- Lower interest rates make borrowing cheaper and saving less attractive, increasing consumption and shifting AD rightward.
Interest rates affect both consumption and investment, making them a critical determinant of AD.
3. Wealth
- An increase in household wealth (e.g., rising property or stock values) boosts consumption, shifting AD to the right.
- A decrease in wealth has the opposite effect, shifting AD to the left.
A booming housing market can increase household wealth, leading to higher consumer spending and a rightward shift in AD.
4. Income Taxes
- Lower income taxes increase disposable income, boosting consumption and shifting AD rightward.
- Higher taxes reduce disposable income, decreasing consumption and shifting AD leftward.
Don’t confuse income taxes with indirect taxes like VAT. Income taxes directly affect disposable income, while indirect taxes impact the prices of goods and services.
5. Household Indebtedness
- High levels of debt discourage spending as households focus on repayments, shifting AD leftward.
- Lower debt levels free up income for consumption, shifting AD rightward.
6. Expectations of Future Prices
- If consumers expect prices to rise, they may spend more now, shifting AD to the right.
- If they expect prices to fall, they may delay spending, shifting AD to the left.
How would a decrease in interest rates affect the AD curve? Explain your reasoning.
