Over at TheMoneyIllusion I've been having a discussion of aggregate demand. What does the term actually mean? In the comment section I see lots of average people giving common sense explanations, and also experts like Nick Rowe making high-level arguments. It might help if I walked people through the various levels of enlightenment:
Level 1: If people decide to spend less, then aggregate demand will fall. By "spend less" the speaker usually means save a larger fraction of their income.
Level 2: But saving equals investment, so if society saves more it will invest more. You are "spending more" on investment projects.
Level 3: But planned savings may exceed planned investment.
Level 4: In that case interest rates will fall, equalizing actual saving and investment.
Level 5: But perhaps it's income that falls, and that is what equalizes actual saving and actual investment.
Level 6: But why should income fall? How does an attempt to save more reduce M*V?
Level 7: If you try to save more and as a result interest rates fall, then velocity will tend to decline, as there is a lower opportunity cost of holding onto cash.
Level 8: Yes, velocity would fall, but I asked why M*V would fall. If the central bank uses the Taylor Rule, or if it targets inflation or NGDP, it will adjust the money supply to prevent M*V from falling.
Level 9: That may be true if interest rates are positive, but at the zero bound they cannot offset the fall in V.
Level 10: Sure they can. There is nothing special about the zero bound in interest rates. All that matters is the zero bound in eligible assets left to buy. And no central bank has ever come close to that zero bound. No central bank has ever said they were out of ammunition.
Level 11: But central banks are reluctant to do unconventional monetary policies at the zero bound, and hence if people try to save more, then M will not fully offset V.
I could go on and on, but I decided to let my opponents have the last word. After all, this "enlightenment" stuff is kind of arrogant. Now let's consider an extra 100 million immigrants suddenly flooding into the US. Does this raise AS or AD?
Level 1: Clearly AD rises, there are lots more shoppers!
Level 2: No, that's an AS shock, there are lots more workers.
Level 3: It depends on the monetary policy. Under the gold standard M is unaffected. So it's a positive supply shock and the wave of immigration causes deflation. Remember 1865-96?
Level 4: No, the wave of immigrants raises the return to capital. Interest rates rise and velocity increases. Both AS and AD rise.
Level 5: But we are probably not at the zero bound if 100 million immigrants pour in, and we now have fiat money, so it entirely depends on whether the central bank is targeting inflation or NGDP.
The textbook AD curve generally assumes a constant money supply. Thus it might be viewed as a gold standard model. That doesn't mean that it can't be applied to fiat regimes, but you need to keep in mind that "supply shocks" could cause central bank reactions that lead to a simultaneous shift in the AD curve.
It's also important to be clear with one's language. If the central bank is targeting NGDP and 100 million people flood into the US then it is clearly a supply shock, AD doesn't change. But the aggregate quantity of goods purchased (demanded) will soar much higher, with the population growth. The stores will be overflowing with shoppers. Lots more aggregate quantity demanded, but no increase in aggregate demand. When you have a mental image of lots of shoppers, don't think you are visualizing AD. You are visualizing equilibrium quantity, which can reflect AD or AS shocks. The same is true of individual markets. The big surge in shoppers purchasing PCs in the 1990s was mostly a supply story, as evidenced by the falling prices.
You may think I'm being picky about language, but it really is important to keep these distinctions clear.
The other takeaway is that common sense notions about "spending" are a very misleading way of thinking about AD. After all, AD isn't just consumption, it's also I + G + NX. Your initial common sense view may be right in the end, as we saw in the 11 stages of enlightenment, but it will be right for the same reason that a broken clock gives the correct time twice a day.
I increasingly think it is a mistake to draw too sharp a distinction between aggregate demand and aggregate supply, at least beyond the very first round of an economic shock.
I sympathize, as the shocks are often "entangled." I'd like to dispense with all discussion of AS and AD, and replace it with nominal shocks and real shocks. A nominal shock is an unexpected change in NGDP. A real shock changes the price/output split for any given level of NGDP. As Tyler suggests, one type of shock is often entangled with the other. But it's still important to keep them clear as a theoretical matter, so that we can think clearly about how monetary policy should respond (or not respond) to various types of situations.