7.4 Shifts in AD and AS Curves
5 min read•august 15, 2024
Shifts in aggregate demand and supply curves are key to understanding macroeconomic fluctuations. These shifts can be caused by various factors, from changes in to technological advancements, and have significant impacts on output and price levels.
Understanding the causes and effects of these shifts is crucial for policymakers. Fiscal and monetary policies can be used to counteract unwanted shifts, while supply-side policies aim to boost long-term economic growth by shifting the aggregate supply curve outward.
Shifts in AD and AS curves
Causes of Shifts in the AD Curve
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- Changes in consumption spending (C) shift the AD curve
- Consumer confidence affects willingness to spend vs. save (stock market performance)
- Wealth effects from changes in asset values (housing prices)
- Disposable income changes from tax cuts or transfers (stimulus checks)
- Interest rate changes affect borrowing costs and spending (mortgage rates)
- Changes in (I) shift the AD curve
- Business confidence in future profitability (CEO surveys)
- Interest rates affect cost of borrowing for investment projects (corporate bond yields)
- Changes in taxes on businesses (depreciation allowances)
- Technological advancements that increase expected ROI (AI, automation)
- Changes in government spending (G) directly shift the AD curve
- Discretionary changes (infrastructure spending)
- Automatic stabilizers like unemployment benefits or progressive taxes
- Changes in net exports (NX) shift the AD curve
- Economic growth or recessions in major trading partners (Eurozone crisis)
- Relative prices of domestic vs. foreign goods (exchange rates)
- Trade policies like tariffs or quotas (US-China trade war)
Causes of Shifts in the AS Curve
- Changes in shift the AS curve
- Nominal wages affect cost of labor (minimum wage increases)
- Energy and raw material costs (oil price shocks)
- Exchange rate fluctuations affect imported input prices (strong dollar)
- Changes in productivity shift the AS curve to the right
- Technological progress allows more output per unit of input (assembly lines)
- Investments in physical capital (factories, equipment)
- Investments in human capital and education (college degrees)
- Changes in legal and institutional environment shift the AS curve
- Government regulations that affect production costs (pollution standards)
- Taxes or subsidies for businesses (corporate tax cuts)
- Property rights and contract enforcement (patent protections)
- Labor market policies (unionization, hiring/firing rules)
Simultaneous Shifts in AD and AS
Relative Magnitudes Determine Outcomes
- If AD increases more than AS, both price and output increase
- Demand-pull inflation scenario (post-COVID reopening)
- If AS increases more than AD, price decreases and output increases
- Beneficial (fracking revolution lowering energy costs)
- If AD decreases more than AS, both price and output decrease
- Recessionary scenario (2008 financial crisis)
- If AS decreases more than AD, price increases and output decreases
- Stagflation scenario (1970s oil embargoes)
Shifts in Same Direction
- If both AD and AS increase, output definitely increases, price effect ambiguous
- Depends which curve shifts more (1990s tech boom)
- If both AD and AS decrease, output definitely decreases, price effect ambiguous
- Depends which curve shifts more (COVID-19 lockdowns)
Supply Shocks
- Sudden shift in AS can cause stagflation or its opposite
- Stagflation = rising prices + falling output (1970s oil shocks)
- Reverse = falling prices + rising output (2014-16 oil price crash)
- Presents challenge for policymakers - which problem to prioritize?
Expectations and AD/AS Shifts
Expectations Affect Current Decisions
- Consumers base spending on expected future income, prices, economic conditions
- Sentiment indexes survey consumer expectations (University of Michigan)
- If expect higher income, more likely to spend now (wealth effect)
- If expect higher prices, buy now before prices rise (hoarding TP during COVID)
- Businesses base investment and hiring on expected future sales, costs, economy
- If expect higher sales and profits, expand production (Keynesian animal spirits)
- If expect input costs to rise, may stockpile inventories (computer chip shortages)
- Workers base wage demands on expected future prices and labor market
- If expect higher inflation, demand cost-of-living adjustments (union contracts)
- If expect plentiful job opportunities, more likely to quit or demand raise (Great Resignation)
Self-Fulfilling Prophecies
- Changes in expectations can lead to behavior changes that validate expectations
- Even if initial expectation unfounded (bank runs)
- Makes economy more volatile and difficult to stabilize
- Policymakers aim to manage expectations (forward guidance)
- Inflation expectations particularly important
- Affect wage and price setting behavior
- Can spiral out of control if not anchored (hyperinflation)
- Credible central bank can anchor expectations (inflation targeting)
Policy Responses to AD/AS Shifts
Fiscal Policy
- Government spending and tax changes can shift AD
- Expansionary = ↑G or ↓T to counter recession (2009 stimulus)
- Contractionary = ↓G or ↑T to counter inflation (1990s deficit reduction)
- Effectiveness depends on several factors
- Size of multiplier (marginal propensity to consume)
- Crowding out of private sector activity (government borrowing)
- Implementation and impact lags (infrastructure projects)
- Ricardian equivalence and expectations (expect future taxes)
Monetary Policy
- Central bank changes money supply and interest rates to shift AD
- Expansionary = ↑M or ↓i to counter recession (2008 QE)
- Contractionary = ↓M or ↑i to counter inflation (1980s Volcker)
- Effectiveness depends on transmission mechanisms
- Interest rate sensitivity of C and I (housing market)
- Strength of credit channel to businesses and households (2008 crunch)
- Expectations and credibility of central bank (dot plot)
- Implementation and impact lags (long and variable)
Supply-Side Policies
- Aim to increase productivity and AS for long-run growth
- Deregulation to reduce compliance costs (1980s Reaganomics)
- Tax cuts and incentives for R&D and innovation (patent box)
- Infrastructure and education investments (human capital)
- Trade liberalization and competition (1990s globalization)
- Often difficult to evaluate effectiveness
- Long time horizons for effects to materialize
- Hard to disentangle from other contemporaneous factors
- May increase inequality even if they increase growth (Kuznets curve)
Key Terms to Review (18)
AD-AS Model: The AD-AS model, or Aggregate Demand-Aggregate Supply model, is a framework used to analyze the overall economy by depicting the relationship between total spending (aggregate demand) and total production (aggregate supply). This model helps explain price levels, output, and economic fluctuations, making it essential for understanding various macroeconomic concepts, such as shifts in demand and supply, business cycles, and the impact of fiscal and monetary policies.
Classical Economics: Classical economics is a school of thought that emerged in the late 18th and early 19th centuries, emphasizing free markets, the self-regulating nature of economies, and the idea that supply creates its own demand. This perspective is critical for understanding how economies operate over time, particularly regarding production, labor, and the long-term growth of national income.
Consumer confidence: Consumer confidence refers to the degree of optimism that households feel about the overall state of the economy and their personal financial situation. It plays a crucial role in influencing consumer spending, which is a significant component of economic activity. Higher consumer confidence typically leads to increased spending, while lower confidence can result in decreased consumption, impacting economic growth.
Demand shock: A demand shock is an unexpected event that causes a sudden increase or decrease in demand for goods and services within an economy. This shift in demand can lead to significant changes in output, prices, and overall economic activity, as businesses and consumers adjust to the new demand levels. Understanding how demand shocks influence economic equilibrium, shift aggregate demand and supply curves, and interact with the multiplier effect is crucial for analyzing economic fluctuations.
Equilibrium: Equilibrium refers to a state in the economy where aggregate demand (AD) equals aggregate supply (AS), resulting in a stable price level and output. This balance signifies that the quantity of goods and services demanded matches the quantity supplied, leading to no inherent pressures for change. At equilibrium, the economy operates efficiently, reflecting optimal resource allocation and price stability.
Fiscal Policy: Fiscal policy refers to the use of government spending and taxation to influence the economy. It plays a crucial role in managing economic activity, affecting levels of demand, inflation, and overall economic growth by adjusting public expenditure and revenue collection.
GDP Growth Rate: The GDP growth rate measures how quickly a country's economy is expanding or contracting over a specific period, usually expressed as a percentage. It is an essential indicator of economic health and helps in understanding the overall performance of an economy in relation to its past growth and the growth of other economies.
Inflation Rate: The inflation rate is the percentage increase in the general price level of goods and services over a specific period, typically measured annually. It reflects how much prices have risen compared to a previous time frame, influencing purchasing power, economic stability, and monetary policy decisions.
Input Prices: Input prices refer to the costs associated with the resources or materials used in the production of goods and services. Changes in these prices can significantly impact the overall cost of production, influencing the supply side of the economy and affecting decisions made by businesses.
Investment spending: Investment spending refers to the expenditure on capital goods that will be used to produce goods and services in the future. This type of spending is crucial for economic growth as it leads to increased production capacity and innovation. It plays a significant role in the economy by affecting aggregate demand and influencing shifts in both the aggregate demand and supply curves, as well as having implications for interest rates and government policy.
IS-LM Model: The IS-LM model represents the interaction between the goods market and the money market in an economy, showing how interest rates and output are determined simultaneously. It helps explain how fiscal and monetary policy can influence overall economic activity, connecting essential concepts like aggregate demand and supply shifts, crowding out effects, and the phases of the business cycle.
John Maynard Keynes: John Maynard Keynes was a British economist whose ideas fundamentally changed the theory and practice of macroeconomics, particularly during the 20th century. He is best known for advocating that government intervention is necessary to stabilize economic cycles and to promote full employment and economic growth.
Keynesian Economics: Keynesian economics is an economic theory that emphasizes the role of government intervention in stabilizing the economy through fiscal and monetary policies. It suggests that during periods of economic downturns, increased government spending and lower taxes can help stimulate demand, which in turn can lead to economic recovery. This approach contrasts with classical economics, advocating for active policy responses to mitigate recessions and support full employment.
Milton Friedman: Milton Friedman was an influential American economist known for his strong belief in the importance of free markets and limited government intervention in the economy. His ideas significantly shaped macroeconomic thought, particularly around consumption, inflation, and monetary policy, advocating for the role of money supply in influencing economic activity.
Monetary Policy: Monetary policy refers to the actions taken by a country's central bank to manage the money supply and interest rates in order to achieve specific economic goals, such as controlling inflation, stabilizing currency, and fostering economic growth. This policy plays a crucial role in influencing overall economic activity and can be adjusted to respond to changing economic conditions.
Output Gap: The output gap is the difference between the actual output of an economy and its potential output, often expressed as a percentage of potential output. When the actual output exceeds potential output, it indicates an economy is overheating, while a negative output gap shows underutilization of resources. This concept connects to various macroeconomic themes, such as measuring economic performance, understanding unemployment causes and consequences, analyzing shifts in aggregate demand (AD) and aggregate supply (AS), and contrasting classical and Keynesian economic perspectives.
Supply shock: A supply shock is an unexpected event that suddenly changes the supply of a product or commodity, leading to significant shifts in prices and economic activity. These shocks can result from natural disasters, geopolitical events, or sudden changes in production costs, affecting the overall economy by shifting the aggregate supply curve. This change can influence inflation and output levels, creating ripples throughout economic indicators.
Technological Innovation: Technological innovation refers to the development and application of new technologies that significantly improve products, processes, or services. This type of innovation is a critical driver of productivity and economic growth, as it can lead to more efficient production methods, the creation of new markets, and enhanced quality of life. Technological innovation is closely linked to investment in research and development, which fosters an environment where ideas can flourish and be transformed into practical applications.