Understanding Shifts in Aggregate Demand and Supply | CFA Level I Economics

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

Today, we’re exploring the factors that cause shifts in aggregate demand, long-run aggregate supply, and short-run aggregate supply of an economy.

Factors Affecting Aggregate Demand

The aggregate demand curve is downward sloping, and over time, macroeconomic factors can cause it to shift. When factors lead to an increase in demand for domestic goods and services, the demand curve shifts to the right. To understand the factors that affect aggregate demand, remember that GDP is the sum of consumption, investments, government spending, and net exports.

Household Sector:

• Consumer wealth: An increase in disposable income, real estate, or stock market prices can make consumers feel wealthier, leading to more spending.
• Expectations of future income: When consumers expect higher future incomes, they save less and spend more, increasing aggregate demand.

Business Sector:

• Business expectations: Optimism about future sales leads to increased investments, raising aggregate demand.
• Capacity utilization: When companies operate near full capacity, they need to invest more to expand production.

Monetary Policy:

• Expansionary monetary policy: Lower reserve requirements and target interest rates lead to increased money supply, lower interest rates, and more borrowing by households and businesses, which increases aggregate demand.

Fiscal Policy:

• Government spending: Increased government spending directly increases aggregate demand.
• Taxes: Lower taxes result in higher disposable income and corporate net profits, leading to increased consumption and business investments.

International Factors:

• Exchange rates: A weaker domestic currency boosts exports and reduces imports, increasing demand for domestic goods.
• Global economic growth: Strong global growth leads to increased exports, raising aggregate demand.

Factors Affecting Long-Run and Short-Run Aggregate Supply

There are factors that cause the short-run and long-run aggregate supply curves to shift. The long-run aggregate supply (LRAS) curve is vertical at the economy’s potential level of real GDP. Potential GDP can increase as the economy’s resource base grows, shifting the LRAS curve to the right.

Resource Base:

• Labor, natural resources, and physical capital: Increases in the supply of these resources shift the LRAS curve to the right.

Qualitative Improvements:

• Human capital: Improved labor force quality through training,skills development, and education shifts the LRAS curve to the right.
• Technology: Technological advancements increase labor productivity and output, shifting the LRAS curve to the right.

Since these factors affect the potential GDP of an economy, they should also shift the short-run aggregate supply (SRAS) curve. However, some factors only cause the SRAS curve to shift, not the LRAS.

Costs of Production:

• Input prices: A decrease in wages, rent, or raw materials lowers production costs, shifting the SRAS curve to the right.
• Strength of local currency: A stronger currency allows firms to import goods at lower prices, reducing production costs and shifting the SRAS curve to the right.
• Taxes and subsidies: Lower taxes or higher subsidies decrease production costs, shifting the SRAS curve to the right.

Expectations of Future Output Prices:

• When businesses expect future output prices to increase, they expand production, increasing SRAS. However, this effect is often transient and modest due to adjustments in input prices.

In the exam, you may be tested on whether a factor affects both SRAS and LRAS, or just SRAS. Use the table below as a summary, but remember that it’s not exhaustive. To determine if a factor affects LRAS, consider whether it impacts the resource base or productivity of the economy (i.e., potential GDP).

Summary Table of Factors Affecting Aggregate Supply

In our next lesson, we will explore why factors like changes in input prices have no impact on the potential GDP of an economy.