Aggregate demand (AD) is the total amount of goods and services consumers are willing to purchase in a given economy and during a certain period. Sometimes aggregate demand changes in a way that alters its relationship with aggregate supply (AS), and this is called a "shift."
Since modern economists calculate aggregate demand using a specific formula, shifts result from changes in the value of the formula's input variables: consumer spending, investment spending, government spending, exports, and imports.
- Aggregate demand (AD) is the total amount of goods and services in an economy that consumers are willing to purchase during a specific time frame.
- When aggregate demand changes in its relationship with aggregate supply, this is known as a shift in aggregate demand.
- Aggregate demand consists of the sum of consumer spending, investment spending, government spending, and the difference between exports and imports.
- When any of these aggregate demand inputs change, then there is a shift in aggregate demand.
The Formula for Aggregate Demand
AD=C+I+G+(X−M)where:C=Consumer spending on goods and servicesI=Investment spending on business capital goodsG=Government spending on public goods and servicesX=ExportsM=Imports
Any aggregate economic phenomena that causes changes in the value of any of these variables will change aggregate demand. If aggregate supply remains unchanged or is held constant, a change in aggregate demand shifts the AD curve to the left or to the right.
In macroeconomic models, right shifts in aggregate demand are typically viewed as a good sign for the economy, meaning that aggregate demand has increased. Shifts to the left, a decrease in aggregate demand, are typically viewed negatively.
Shifting the Aggregate Demand Curve
The aggregate demand curve tends to shift to the left when total consumer spending declines. Consumers might spend less because the cost of living is rising or because government taxes have increased.
Consumers may decide to spend less and save more if they expect prices to rise in the future. It might be that consumer time preferences change and future consumption is valued more highly than present consumption.
Contractionary fiscal policy can also shift aggregate demand to the left. The government might decide to raise taxes or decrease spending to fix a budget deficit. Monetary policy has less immediate effects. If monetary policy raises the interest rate, individuals and businesses tend to borrow less and save more. This could shift AD to the left.
The last major variable, net exports (exports minus imports), is less direct and more controversial. A country that runs a current account is always balanced by the capital account. The corresponding capital account surplus might raise government spending if foreign agents use their dollars to buy Treasury bonds (T-bonds). If they use those dollars to invest in U.S. businesses, the investment spending on capital goods might rise.
For every possible cause of a leftward shift in the AD curve, there is an opposite possible rightward shift. Increased consumer spending on domestic goods and services can shift AD to the right. It is possible that a declining marginal propensity to save (MPS) can also shift AD to the right. An expansionary monetary and fiscal policy might increase aggregate demand. All of these effects are the inverse of the factors that tend to decrease aggregate demand.
Aggregate Demand Shock
According to macroeconomic theory, a demand shock is an important change somewhere in the economy that affects many spending decisions and causes a sudden and unexpected shift in the aggregate demand curve.
Some shocks are caused by changes in technology. Technological advances can make labor more productive and increase business returns on capital. This is normally caused by declining costs in one or more sectors, leaving more room for consumers to buy additional goods, save, or invest. In this case, the demand for total goods and services increases at the same time prices are falling.
Diseases and natural disasters can cause demand shocks if they limit earnings and cause consumers to buy fewer goods. For example, Hurricane Katrina caused negative supply and demand shocks in New Orleans and the surrounding areas. The United States' entry into WWII is also commonly held as a historical example of a demand shock.
The Bottom Line
Aggregate demand is the total amount of goods and services in an economy that consumers are willing to pay for within a certain time period. Aggregate demand is calculated as the sum of consumer spending, investment spending, government spending, and the difference between exports and imports.
Whenever one of these factors changes and when aggregate supply remains constant, then there is a shift in aggregate demand. Utilizing the aggregate demand curve, a shift to the left, a reduction in aggregate demand, is perceived negatively, while a shift to the right, an increase in aggregate demand, is perceived positively.