Aggregate Demand Shock

An aggregate demand shock occurs when total spending in the economy changes suddenly due to shifts in consumer confidence, business investment, or government policy. These changes stem from how people feel about the future, how businesses plan investments, or how much government spends. Such shifts affect the total amount of goods and services purchased across the entire economy.

A negative demand shock happens when consumers cut back purchases or firms delay investment, reducing total spending. Businesses face declining sales, leading them to reduce production and lay off workers in the short run. The aggregate demand curve shifts leftward, output falls, and prices decrease as businesses try to attract buyers.

A positive demand shock occurs when consumer spending, government expenditure, or exports rise, shifting the aggregate demand curve rightward. Output and prices both increase, creating inflationary pressure. Businesses respond by hiring more workers and producing more goods to meet the higher demand.

Wages and prices adjust slowly in the short run, creating a gap between lower sales and high running costs. This delay means businesses cannot immediately reduce costs when demand falls, which can hurt profits and lead to layoffs. The lag in wage and price adjustment explains why demand shocks cause short-run fluctuations in output and employment.

When a negative demand shock occurs, the aggregate demand curve shifts leftward from AD₁ to AD₂. The economy moves to a new short-run equilibrium point where output falls from Y₁ to Y₂ and the price level decreases from P₁ to P₂. This creates a recessionary gap between actual output and potential output.

Demand shocks don't impact all parts of the economy equally. Some industries feel the impact more than others, depending on what people are spending money on. Even if supply conditions remain unchanged, sudden shifts in demand cause big changes in output, employment, and prices across different sectors.

Planned aggregate expenditure reflects total spending decisions by consumers, businesses, and government. When these spending plans change suddenly, they trigger demand shocks that shift the aggregate demand curve. Understanding planned aggregate expenditure and the interest rate helps explain how monetary policy and consumer confidence influence demand shocks.