Introduction
Welcome back! In our previous lesson, we established the economy's long-run supply capacity by defining potential GDP and the sustainable rate of growth. This represents the economy's production "speed limit" and is depicted by the vertical Long-Run Aggregate Supply (LRAS) curve.
Now, we turn our attention to the other side of the economy: total spending. To understand short-term economic fluctuations—the business cycles that affect investment returns and corporate profits—we must analyze the demand side.
This lesson introduces the concept of Aggregate Demand (AD). By the end of our 60 minutes, you will be able to describe the components of the AD curve and, crucially, explain the various factors that cause it to shift. This is the next major step in building the full Aggregate Demand-Aggregate Supply (AD-AS) model, a cornerstone of macroeconomic analysis for the CFA exam.
1. Understanding the Aggregate Demand Curve
Aggregate Demand (AD) represents the total quantity of all domestically produced goods and services that households, firms, the government, and foreigners are willing and able to buy at different price levels.
The AD curve is graphed with the overall price level on the vertical axis and real GDP (total output) on the horizontal axis. It slopes downwards, but for reasons quite different from the demand curve for a single product.
To get a clear and concise explanation of the AD curve and why it slopes downward, let's watch a short video.
Aggregate Demand- Macro Topic 3.1
This video from Jacob Clifford introduces the AD curve and explains the three key macroeconomic effects that cause its downward slope.
Watch the video from the beginning until 03:07. Focus on: The definition of Aggregate Demand and the axes of the graph. The three reasons for the downward slope: the real wealth effect, the interest rate effect, and the exchange rate effect. Make sure you understand how each effect links a change in the price level to a change in the quantity of real GDP demanded.
To recap the video's key points, the AD curve slopes downward due to:
- The Wealth Effect: A lower price level increases the real value of households' financial assets (like cash and bonds), making them feel wealthier. This encourages them to spend more, increasing the consumption component of AD.
- The Interest Rate Effect: A lower price level means households need less cash for transactions. They save more, increasing the supply of loanable funds, which lowers interest rates. Lower interest rates stimulate borrowing for investment by firms and for large purchases by consumers, increasing the investment and consumption components of AD.
- The Exchange Rate Effect: A lower price level in a country leads to lower interest rates (as per the interest-rate effect). This can cause the domestic currency to depreciate, as investors seek higher returns elsewhere. A weaker currency makes domestic goods cheaper for foreigners and foreign goods more expensive for domestic residents, thus increasing net exports.
It is critical to remember that these effects describe a movement along the AD curve, caused by a change in the overall price level.
2. Components of Aggregate Demand & Shifters
As you've likely noticed, the logic behind the AD curve is tied to the components of Gross Domestic Product (GDP). The formula for aggregate demand is identical to the expenditure approach for calculating GDP:
Where:
- C = Consumption spending by households
- I = Investment spending by firms
- G = Government spending on goods and services
- (X - M) = Net Exports (Exports minus Imports)
This image provides a great visual summary of the components and the factors that influence them.
A change in any of these components for a reason other than a change in the price level will cause the entire AD curve to shift. An increase in AD is a rightward shift, and a decrease is a leftward shift. Confusing a movement along the curve with a shift is a common mistake.
Now, let's look at the factors that cause these shifts.
Aggregate Demand- Macro Topic 3.1
We'll continue with the same Jacob Clifford video, which now provides an excellent, scenario-based overview of the shifters of aggregate demand.
Watch from 03:07 to the end. The video presents six scenarios. Pause and try to determine the effect on AD yourself before the explanation is given. This is great practice for exam-style questions.
The video gave you a dynamic look at the AD shifters. For a more structured and comprehensive list, which is essential for your CFA studies, please read the following text.
Movements Along and Shifts in Aggregate Demand and Supply Curves
This reading from AnalystPrep, a CFA prep provider, details the factors that shift the AD curve. It uses terminology and framing that you will encounter in the CFA curriculum.
Please read the section titled 'Shifts in the Aggregate Demand Curve'. Pay close attention to how each factor influences one of the components (C, I, G, or NX) to shift the AD curve.
To solidify your understanding of the crucial difference between the shape of the AD curve and shifts of the curve, review this helpful table.
| Aspect | Shape of AD Curve (Movement Along) | Shift of AD Curve |
|---|---|---|
| Definition | The downward-sloping relationship between the price level and the quantity of AD. | A movement of the entire AD curve to the right (increase) or left (decrease). |
| Cause | A change in the price level. | A change in C, I, G, or NX due to factors other than the price level. |
| Underlying Reason | The wealth effect, interest rate effect, and exchange rate effect. | Changes in consumer/business confidence, fiscal policy, monetary policy, global economic conditions, etc. |
| Economic Implication | Shows how much total spending changes when inflation rises or falls. | Indicates a change in the overall level of demand at every price level. |
Source: Adapted from "Shape and shifts of AD curve" (LINK).
3. Practice Question
Let's test your understanding with a question similar to what you might see on the exam.
Movements Along and Shifts in Aggregate Demand and Supply Curves
Attempt this multiple-choice question from the AnalystPrep article you just read. Focus on identifying whether the factor described causes a movement along the curve or a shift.
Read the question, decide on your answer, and then carefully read the provided solution to confirm your reasoning.
The key to the question is recognizing that a change in household wealth is a non-price factor that directly affects consumption (C), causing the entire AD curve to shift. A change in the price level, while it does impact spending via the wealth effect, causes a movement along the curve, not a shift of it.
Conclusion
In this lesson, we have constructed the demand side of our macroeconomic model. We have seen that Aggregate Demand is the sum of all spending in an economy and that its curve has a negative slope for specific macroeconomic reasons.
Key Takeaways:
- Aggregate Demand (AD) is the total demand for goods and services in an economy, given by the formula .
- The AD curve slopes downward due to the wealth effect, interest rate effect, and exchange rate effect. These explain how a change in the price level causes a movement along the AD curve.
- The entire AD curve shifts when there are changes in factors that affect its components () for reasons other than a change in the price level.
- Key shifters include:
- Fiscal Policy: Changes in government spending (G) or taxes (which affect C and I).
- Monetary Policy: Changes in interest rates or the money supply (which affect I and C).
- Expectations: Changes in consumer and business confidence (affecting C and I).
- Global Factors: Changes in foreign incomes or exchange rates (affecting NX).
Preview of the Next Lesson:
We have now examined the long-run supply (LRAS) and aggregate demand (AD). The final piece of the puzzle is the Short-Run Aggregate Supply (SRAS) curve. In our next lesson, we will describe the SRAS curve, explain why it slopes upward, and identify the factors that cause it to shift. Once we have the SRAS, we can bring all three curves together to analyze how the economy behaves in the short run.