Aggregate demand (AD) and aggregate supply (AS) curves are used to address economic issues such as expansions and contractions of the economy, causes of inflation, and changes in unemployment levels. Movements along these curves curve are caused by price level variations while shifts of these curves happen when some other variable (other than the price level) affects the demand for goods and services changes.
Movement along the Aggregate Demand Curve
Movements along the aggregate demand curve are mainly caused by prices. When the price level rises, the amount of real money supply declines, forcing the interest rates to rise. Due to high interest rates, this reduces investments and savings, thus lowering levels of income for a short period of time. When price levels decrease, the real money supply increases. This reduces the interest rate thereby encouraging investments and savings, hence subsequently reincreasing income levels.
Movement along the Aggregate Supply Curve
Price is the main contributor to the movement along the supply curve. In the short run, as price levels increase, businesses report higher profits thus increase their total production level. When price levels fall, they suffer losses thereby reducing production.
Shifts in the Aggregate Demand Curve
Price and other factors influencing the level of expenditure by households, governments, firms, and foreigners will cause a shift in the aggregate demand curve.
Those factors include:
Household wealth incorporates both financial and real assets. Households save part of their income to accumulate wealth. With assets increasing in value, they will be forced to save less and increase spending, thus shift the aggregate demand curve to the right. Conversely, a decrease in wealth reduces consumer spending and shifts the aggregate demand curve left. This is commonly called by economists the wealth effect.
Consumer and Business Expectations
When consumers have higher confidence in staying out of unemployment, they have the tendency to consume more, thus shifting the aggregate demand curve to the right. However, when consumers lack confidence, spending declines, shifting the AD curve to the left. For example in the US, AIM’s Business Confidence Index is a widely followed economic indicator used by employers, traders, and governments to gauge the sentiment of consumers.
Capacity utilization is a measure of how the economy’s production capacity is fully utilized. Businesses running below full capacity are often willing to increase their investment spending during economically good times. This makes the aggregate demand curve shift rightward.
Fiscal policy refers to the use of taxes and government spending to affect the level of aggregate expenditure. The rise in government expenditure shifts the aggregate demand curve rightward, while a reduction in government expenditure shifts the curve to the left. This can be seen in almost every country, but most notably in the US where infrastructure spending has been a top priority for governments in the last decade. The bet that the governments are making is that keeping people employed will have them spend more and subsequently stimulate the economy.
Low taxes lead to a high proportion of personal income and corporate pre-tax profits and thus the individual consumers and the business entities have more to spend shifting the AD curve to the right. On the other hand, high taxes will shift AD to the left.
Monetary policy refers to the method by a country’s central bank to alter aggregate output and prices by changing bank reserves and reserve requirements. Central banks, through various monetary policies, control the money supply. An increase in the money supply causes a rightward shift in the aggregate demand curve, whereas a reduction in the money supply shifts the aggregate demand curve leftward.
Growth in the Global Economy
Through international trade, countries are connected to form a global economy. A rapid growth in a foreign country encourages foreigners to buy more products from the domestic country, increasing the exports of the domestic country. This, in turn, shifts the AD of the domestic country to the right. This will also imply that a decline in growth rate in the exporting country will affect the AD of the importing country.
Change in Exchange Rates
An exchange rate refers to the price of one currency in relation to another. Changes in exchange rates affect the prices of exports and imports, which is translated to AD. For example, a lower Canadian Dollar in relation to other currencies makes Canadian exports cheaper and foreign products sold in Canada expensive, shifting the AD curve of Canada to the right and vice versa.
Shifts in the Aggregate Supply Curve
Factors that influence the cost of production will cause a shift in the aggregate supply curve in the short and long run.
These factors include:
An increase in nominal wages results in an increase in production costs, hence a leftward shift in the aggregate supply curve. A decrease in nominal wages results in a shift to the right.
Higher inputs prices increase production costs, hence cause reduced output, resulting in a leftward shift in the aggregate supply curve. Lower prices reduce the cost of production which produces a leftward shift.
Taxes and Subsidies
Increased taxes result in high production costs that shift the curve to left. Reduced taxes and subsidies reduce production costs, causing a shift to the right.
These factors include:
Productivity and Technology
With high productivity and developed technology, the cost of production thus shifts the aggregate supply curve both in a long and short-run right. Conversely, poor technology shifts the curve to the left.
Supply of Labor
When the supply of labor in a country is large, the country is then able to produce more goods and services. This shifts the LRAS to the right. Conversely, a decrease in labor shifts the curve to the left.
Supply of Natural Resources
Natural resources include oil, water, etc. The ready availability of natural resources will shift the LRAS to the right.
Supply of Physical Capital
An increase in physical capital will, in turn, increase the capacity of the economy to produce goods and services. For instance, improvement in working conditions for workers will increase the output shifting the LRAS to the right.
Supply of Human Capital
This involves improving the quality of the labor force by training, skill development, and education. This will, in turn, shift the LRAS to the right.
Which of the following causes shifts of the aggregate demand (AD) curve?
A. A change in the price level
B. A change in household wealth
C. Both A and B
The correct answer is B.
Shifts of the AD curve happen when some other variable (other than the price level) affects the demand for goods and services changes. Households save part of their income to accumulate wealth. With assets increasing in value, households will be forced to save less and increase spending, thus shift the aggregate demand curve to the right.
Option A is incorrect. Movements along the aggregate demand curve are caused by price level variations. As such, Option C is also incorrect.
Reading 14 LOS 14h:
Explain causes of movements along and shifts in aggregate demand and supply curves