What Factors Cause Shifts in Aggregate Demand?

Aggregate demand (AD) is the total amount of goods and services that 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). This is called a “shift.”

Modern economists calculate aggregate demand using a specific formula so shifts result from changes in the value of the formula’s input variables: consumer spending, investment spending, government spending, and exports minus imports.

The Formula for Aggregate Demand

$begin{aligned} &AD=C+I+G+(X-M)\ &textbf{where:}\ &C = text{Consumer spending on goods and services}\ &I = text{Investment spending on business capital goods}\ &G = text{Government spending on public goods and services}\ &X = text{Exports}\ &M = text{Imports} end{aligned}$​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​

Aggregate economic phenomena that cause changes in the value of any of these variables will change aggregate demand. A change in aggregate demand shifts the AD curve to the left or the right if aggregate supply remains unchanged or is held constant.

Right shifts in aggregate demand in macroeconomic models are typically viewed as a sign that aggregate demand increased or is growing. This is typically viewed as positive. Shifts to the left indicate a decrease in aggregate demand and mean that the economy is declining or shrinking. This is typically viewed as negative.

But this is not always the case. A reduction in aggregate demand might be engineered by the government to reduce inflation, which is not necessarily negative.

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. They may decide to save more if they expect prices to rise in the future. Conversely, they might spend more now while prices are lower if they expect them to cost more later, causing an opposite effect.

It might also be that consumer time preferences change and future consumption is valued more highly than present consumption.

This image shows the shift that aggregate demand makes in response to changes in inputs.

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. Individuals and businesses tend to borrow less and save more when monetary policy raises the interest rate. This could shift AD to the left.

The last major variable is net exports or exports minus imports. It’s less direct and more controversial.

A country’s current account surplus is always balanced by the change in the capital account. A trade surplus (or positive net exports) would imply a net influx of foreign currency or dollars held abroad to pay for the fact that foreigners are buying more U.S. goods than they’re selling to the U.S.

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. The demand for total goods and services increases while prices fall in this case.

Diseases and natural disasters can cause negative demand shocks if they limit earnings and cause consumers to buy fewer goods. Hurricane Katrina caused negative supply and demand shocks in New Orleans and the surrounding areas. And it’s commonly held that the United States experienced a positive demand shock post-WWII, particularly with real commodities.

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 period. It’s calculated as the sum of consumer spending, investment spending, government spending, and the difference between exports and imports.

There’s a shift in aggregate demand whenever one of these factors changes and when aggregate supply remains constant. A shift to the left or reduction in aggregate demand is perceived negatively utilizing the aggregate demand curve while an increase in aggregate demand or a shift to the right is perceived positively.

Correction–April 20, 2024: This article has been corrected to state that when prices are low consumers may spend more if they expect prices to rise in the future, which would affect aggregate demand.