IB DP Economics - Unit 3 - Shifts of the AD curve caused by changes in determinants-Study Notes - New Syllabus

Shifts of the Aggregate Demand (AD) Curve Caused by Changes in Determinants

A shift of the aggregate demand (AD) curve occurs when there is a change in one or more non-price determinants of aggregate demand.

This causes the quantity of real output demanded to change at every price level.

Change in AD determinant → Entire AD curve shifts

The aggregate demand curve may:

• Shift to the right → Increase in AD
• Shift to the left → Decrease in AD

Increase in Aggregate Demand

An increase in aggregate demand occurs when total spending in the economy rises.

• The AD curve shifts to the right.
• At every price level, more real output is demanded.
• Usually leads to higher output and employment in the short run.

AD increase → Rightward shift

Decrease in Aggregate Demand

A decrease in aggregate demand occurs when total spending in the economy falls.

• The AD curve shifts to the left.
• At every price level, less real output is demanded.
• May lead to recession and unemployment.

AD decrease → Leftward shift

Shifts Caused by Changes in Consumption (\( \mathrm{C} \))

Consumption is the largest component of aggregate demand in most economies. Therefore, changes in consumption strongly affect the AD curve.

1. Consumer Confidence

• Higher confidence increases spending and shifts AD right.
• Lower confidence reduces spending and shifts AD left.

Example:

• If consumers expect stable jobs and rising income, consumption rises.

2. Interest Rates

• Lower interest rates encourage borrowing and consumption.
• Higher interest rates discourage spending.

Interest rates ↓ → Consumption ↑ → AD shifts right

3. Wealth

• Higher asset values increase household wealth and spending.
• Falling wealth reduces consumption.

Example:

• Rising house prices may increase household spending.

4. Income Taxes

• Lower taxes increase disposable income and consumption.
• Higher taxes reduce spending power.

Income taxes ↓ → Consumption ↑ → AD shifts right

5. Household Indebtedness

• High debt may force households to reduce spending.
• Lower debt may support stronger consumption.

6. Expectations of Future Prices

• If consumers expect prices to rise, they spend more now.
• If they expect prices to fall, spending may decrease.

Shifts Caused by Changes in Investment (\( \mathrm{I} \))

Investment is a major source of economic fluctuations because it is highly sensitive to expectations and interest rates.

1. Interest Rates

• Lower interest rates reduce borrowing costs.
• Firms increase investment spending.

Interest rates ↓ → Investment ↑ → AD shifts right

2. Business Confidence

• Optimistic firms invest more.
• Economic uncertainty reduces investment.

3. Technology

• New technology encourages investment in capital goods.
• Firms invest to improve productivity.

4. Business Taxes

• Lower business taxes increase profitability and investment.
• Higher taxes discourage investment spending.

5. Corporate Indebtedness

• High debt burdens may reduce firms’ willingness to invest.

Shifts Caused by Changes in Government Spending (\( \mathrm{G} \))

Government spending directly affects aggregate demand.

1. Political Priorities

• Governments may increase spending on infrastructure, healthcare, or defence.
• This raises aggregate demand.

2. Economic Priorities

• During recessions, governments may use expansionary fiscal policy.
• During inflationary periods, governments may reduce spending.

Government spending ↑ → AD shifts right

Shifts Caused by Changes in Net Exports (\( \mathrm{X – M} \))

1. Income of Trading Partners

• Economic growth abroad increases demand for exports.
• Exports rise, increasing AD.

2. Exchange Rates

• Currency depreciation makes exports cheaper and imports more expensive.
• Net exports rise.

Currency depreciation → Net exports ↑ → AD shifts right

3. Trade Policies

• Export promotion policies increase AD.
• Import restrictions may reduce imports and increase net exports.

Movement Along vs Shift of the AD Curve

Importance of AD Shifts

• Help explain economic expansions and recessions.
• Influence unemployment and inflation.
• Central to fiscal and monetary policy analysis.
• Important in Keynesian macroeconomics.

Summary Table of AD Determinants and Direction of Shift

Key Ideas:

• Shifts of the AD curve occur due to changes in AD determinants.
• Rightward shifts indicate increased spending.
• Leftward shifts indicate decreased spending.
• Changes in consumption, investment, government spending, and net exports all affect AD.