Why does the aggregate demand curve slope downward what shifts the AD curve

Imagine a fixed IS curve and an LM curve shifting hard left due to increases in the price level, as in Figure 22.6 "Deriving the aggregate demand curve". As prices increase, Y falls and i rises. Now plot that outcome on a new graph, where aggregate output Y remains on the horizontal axis but the vertical axis is replaced by the price level P. The resulting curve, called the aggregate demand (AD) curve, will slope downward, as below. The AD curve is a very powerful tool because it indicates the points at which equilibrium is achieved in the markets for goods and money at a given price level. It slopes downward because a high price level, ceteris paribus, means a small real money supply, high interest rates, and a low level of output, while a low price level, all else constant, is consistent with a larger real money supply, low interest rates, and kickin’ output.

Figure 22.6 Deriving the aggregate demand curve

Because the AD curve is essentially just another way of stating the IS-LM model, anything that would change the IS or LM curves will also shift the AD curve. More specifically, the AD curve shifts in the same direction as the IS curve, so it shifts right (left) with autonomous increases (decreases) in C, I, G, and NX and decreases (increases) in T. The AD curve also shifts in the same direction as the LM curve. So if MS increases (decreases), it shifts right (left), and if Md increases (decreases) it shifts left (right), as in Figure 22.3 "Predicted effects of changes in major macroeconomic variables".

The aggregate demand curve shows a relationship between aggregate demand and the general price level.

A fall in the general price level causes an expansion of AD

A rise in the general price level causes a contraction of AD

Why does the aggregate demand curve slope downwards from left to right?

Real income effect: As the price level falls, the real value of income rises, and consumers can buy more of what they want or need – this is known as the real money balance effect

Balance of trade effect: A fall in the relative price of level of Country X could make foreign-produced goods and services more expensive, causing a rise in exports and a fall in imports. Exports are an injection, imports a withdrawal.

Interest rate effect: If price inflation is low and this might lead to a reduction in interest rates if the central bank has a given inflation target. Lower interest rates means there is less incentive to save and a fall in interest rates may cause the exchange rate to depreciate and improve exports.

Shifts in the Aggregate Demand curve

Shifts in the aggregate demand curve are caused by factors independent of changes in the general price level.

An outward shift of AD means a higher level of demand at each price level. One or more of the components of AD must have changed. AD1 shifts to AD2.

An inward shift of AD means that total expenditure on goods and services at each price level has fallen. AD1 shifts to AD3.

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.

Key Takeaways

• 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\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​

Any aggregate economic phenomena that cause 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.

The aggregate demand formula is identical to the formula for nominal gross domestic product.

In macroeconomic models, right shifts in aggregate demand are typically viewed as a sign that aggregate demand increased or is growing—typically viewed as positive. Shifts to the left, a decrease in aggregate demand, mean that the economy is declining or shrinking—typically viewed as negative.

However, this is not always the case. For example, a reduction in aggregate demand might be engineered by the government to reduce inflation, which is not necessarily something 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.

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’s current account surplus is always balanced by the change in the capital account (that is, a trade surplus or positive net exports). This 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 are selling to the U.S. This situation would lead to an increase in U.S. foreign currency holdings or an influx of U.S. dollars held abroad and would generally positively shift 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 negative 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. And post-WWII, it's commonly held that the United States experienced a positive demand shock, 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 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.