7.4 Shifts in AD and AS Curves

Shifts in aggregate demand and supply curves are key to understanding macroeconomic fluctuations. These shifts can be caused by various factors, from changes in consumer confidence 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 investment spending (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 fiscal policy 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 input prices 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 supply shock (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)