Chapter 9 · Aggregate demand and aggregate supply
Shift of the aggregate demand curve
Explain shifts in aggregate demand caused by consumption, investment, government spending or net exports, and their effects on real GDP and prices.
The economic idea
Aggregate demand is total planned expenditure on domestically produced goods and services at different average price levels. It consists of consumption, investment, government expenditure and net exports.
A change in the price level causes movement along AD. The curve shifts only when a non-price determinant changes autonomous planned expenditure—for example consumer confidence, interest rates, business expectations, fiscal policy, foreign income or the exchange rate.
An initial change in autonomous expenditure may create a multiplied change in national income. One person’s spending becomes another person’s income, generating further consumption, although saving, taxation and imports leak income from the spending stream.
In the short run, the effect is shared between real output and the price level because SRAS slopes upward. The relative size of each change depends on spare capacity and the responsiveness of short-run aggregate supply.
Reading an increase in aggregate demand
“Price level” measures the economy-wide price level and “Real GDP” measures real GDP.
“AD₁” is the original expenditure schedule and “AD₂” is the new schedule. “SRAS” remains the short-run production schedule.
“E₁” gives the original price level “P₁” and output “Q₁”. “E₂” gives the new price level “P₂” and output “Q₂” when a distinct shift is visible.
Starting point: E₁
“E₁” is where “AD₁” intersects “SRAS”. It establishes the short-run equilibrium price level “P₁” and real output “Q₁” because planned expenditure equals the output firms are willing to produce.
The change: AD₁ to AD₂
“AD₂” lies to the right of “AD₁”, so aggregate demand has increased. The economy moves from “E₁” to “E₂”: the price level rises from “P₁” to “P₂”, while real output rises from “Q₁” to “Q₂”.
Adjustment along SRAS
The change in expenditure creates excess aggregate demand at the old price level. Firms move along the unchanged “SRAS” as output and the price level adjust toward “E₂”.
Separate the spending trigger from the price response
For example, a central-bank interest-rate cut may encourage consumption and investment, shifting AD right. That is different from the interest-rate effect used to explain movement along an unchanged AD curve when the price level changes.
In an explanation, name the initial spending change, connect it to AD, then use the new intersection to explain real GDP and the price level. A shift drawn on its own does not establish what caused it.
From autonomous expenditure to the new equilibrium
A non-price determinant changes one or more components of AD, moving the schedule from “AD₁” to “AD₂”.
At the old price level, planned expenditure exceeds current output and inventories fall.
Firms adjust production and prices, creating movement along the unchanged “SRAS”.
The process ends at “E₂”. “AD₂” lies to the right of “AD₁”, so aggregate demand has increased. The economy moves from “E₁” to “E₂”: the price level rises from “P₁” to “P₂”, while real output rises from “Q₁” to “Q₂”.
Common mistakes to avoid
- Consumers and firms move along “SRAS” during adjustment; “SRAS” does not shift in this isolated model.
- A lower price level does not shift AD. It causes movement along AD through real-balance, interest-rate and international effects.
- The multiplier is not guaranteed to have its simple textbook size because imports, taxes, saving, capacity constraints and expectations weaken the process.
- A rise in real GDP is not automatically long-run economic growth; it may use previously idle capacity.
How to draw this diagram
- Title the diagram “Shift of the aggregate demand curve”. Label the horizontal axis “Real GDP” and the vertical axis “Price level”.
- Draw AD₁ first and label it clearly.
- Draw SRAS next and label it clearly.
- Draw AD₂ next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Project important intersections to the axes with dashed guide lines and label the outcomes.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The diagram does not identify which AD component changed; evidence is required to choose the correct determinant.
- Multiplier effects may be weakened by saving, taxation, imports, debt repayment and policy responses.
- If the change affects productive capacity or costs, SRAS or LRAS may shift as well.
- The model does not show distributional effects: equal changes in GDP can affect households differently.
- The final price-level effect depends on spare capacity and cannot be inferred from the AD shift alone.