3.2.4 Shifts of the AD curve caused by changes in determinants Notes

Shifts of the Aggregate Demand Curve

1. The aggregate demand (AD) curve shows the total spending on goods and services in an economy at different price levels.
2. When the determinants of AD change, the curve shifts, reflecting an increase or decrease in overall economic activity.

Determinants of Aggregate Demand

The components of aggregate demand are:

• Consumption (C)
• Investment (I)
• Government Spending (G)
• Net Exports (X - M)

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.

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.

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.

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.

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.

Investment (I)

Investment refers to spending by firms on capital goods. Key determinants include:

1. Interest Rates

• Higher interest rates increase borrowing costs, reducing investment and shifting AD leftward.
• Lower interest rates make borrowing cheaper, encouraging investment and shifting AD rightward.

2. Business Confidence

• High confidence in future economic growth encourages firms to invest, shifting AD rightward.
• Low confidence leads to reduced investment, shifting AD leftward.

3. Technology

• Advances in technology often require firms to invest in new equipment, shifting AD rightward.

4. Business Taxes

• Lower taxes increase the profitability of investments, encouraging spending and shifting AD rightward.
• Higher taxes discourage investment, shifting AD leftward.

5. Corporate Indebtedness

• High debt levels limit funds available for investment, shifting AD leftward.
• Lower debt levels free up resources for investment, shifting AD rightward.

Government Spending (G)

Government spending is influenced by:

1. Political Priorities

• Governments may increase spending on public services or infrastructure to achieve political goals, shifting AD rightward.
• Conversely, spending cuts shift AD leftward.

2. Economic Priorities

• During economic crises, governments often increase spending to stimulate demand.
• Austerity measures, such as spending cuts, reduce AD.

3. Trade Policies

• Protectionist measures (e.g., tariffs) can increase net exports by reducing imports, shifting AD rightward.
• Trade liberalization may increase imports, reducing net exports and shifting AD leftward.

Diagram: Shifts of the AD Curve

1. The diagram above illustrates shifts in the AD curve.
2. A rightward shift (from AD1 to AD2) indicates an increase in aggregate demand, while a leftward shift (from AD1 to AD3) shows a decrease.