📉 What Is Aggregate Demand?
Definition: Aggregate demand (AD).
The four components
- C — Consumption — household spending on goods and services (the largest component in most economies, ~60–70% of AD).
- I — Investment — business spending on capital goods (factories, machines, technology).
- G — Government spending — public expenditure on goods and services (not transfer payments).
- (X − M) — Net exports — exports minus imports. Positive if the country sells more abroad than it buys.
Why the AD curve slopes downward
- Wealth effect — lower prices → money balances worth more → people feel wealthier → spend more.
- Interest rate effect — lower prices → less demand for money → interest rates fall → borrowing increases → C and I rise.
- International trade effect — lower domestic prices → exports cheaper, imports dearer → (X − M) rises.
➡️ Shifts of the AD Curve
A change in the price level causes a movement along AD. A change in any other factor shifts the entire AD curve. Here are the main shifters, organised by component:
Factors that shift AD right (increase)
- C increases: rising consumer confidence, lower interest rates, higher wealth, tax cuts.
- I increases: business optimism, lower interest rates, technological breakthroughs, tax incentives for investment.
- G increases: expansionary fiscal policy (more government spending).
- (X − M) increases: weaker exchange rate (exports cheaper), stronger foreign economies, trade agreements.
Factors that shift AD left (decrease)
- Falling confidence (consumer or business), rising interest rates, higher taxes, austerity measures, stronger exchange rate, recession in trading partners.
For any AD shift question, identify which component (C, I, G, or X−M) is affected and why. This shows the examiner a clear chain of reasoning.
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✏️ Drawing AD Correctly
- Y-axis: Average price level (APL or just 'Price level').
- X-axis: Real GDP (or real output / real national income).
- AD slopes downward from left to right.
- Label the curve AD (or AD₁, AD₂ for shifts).
- Show shifts with a new curve and an arrow indicating direction.
Common mistakes: (1) Labelling axes wrong (it's price level, not price). (2) Confusing movements along AD (price level change) with shifts of AD (non-price factor change). (3) Forgetting to label the new curve.
AD is the macroeconomic demand curve. Don't confuse it with the microeconomic demand curve for a single good. AD shows total spending in the economy at each price level.