Aggregate Demand (AD) (AQA A Level Economics)

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Written by: Lorraine

Reviewed by: Steve Vorster

An Introduction to Aggregate Demand

Aggregate demand (AD) is the total demand for all goods and services in an economy at any given average price level
Its value is often calculated using the expenditure approach
- AD = Consumption (C) + Investment (I) + Government spending (G) + (Exports-Imports) (X-M)
- AD = C + I + G + (X-M)
Consumption is the total spending on goods and services by consumers (households) in an economy
Investment is the total spending on capital goods by firms
Government spending is the total spending by the government in the economy
- Includes public sector salaries, payments for provision of merit and public goods etc.
- It does not include transfer payments
Net exports are the difference between the revenue gained from selling goods or services abroad and the expenditure on goods or services from abroad
- Individuals, firms and governments export and import
The relationship between the average price level and the total output in an economy is shown with an aggregate demand (AD) curve

Diagram: Aggregate Demand (AD) Curve for an Economy

Diagram showing aggregate demand for A level Economics — **Average Price Level on the Y axis and Real GDP or Real National Output on the X axis**

Movements Along the Aggregate Demand Curve

Whenever there is a change in the average price level (AP) in an economy, there is a movement along the aggregate demand (AD) curve

Diagram: An Increase & Decrease in the Average Price Level (AP)

Diagram showing an increase and decrease in the average price level for A level Economics — **A change in AP causes a movement along the aggregate demand (AD) curve, leading to a contraction or expansion of AD**

Diagram Analysis

An increase in the AP (ceteris paribus) from AP₁→ AP₂ leads to a movement along the AD curve from A → B
- There is a contraction of real GDP from Y₁ → Y₂
A decrease in the AP (ceteris paribus) from AP₁ → AP₃ leads to a movement along the AD curve from A → C
- There is an expansion of real GDP (output) from Y₁ → Y₃

Factors that Cause the Entire AD Curve to Shift

Whenever there is a change in any of the determinants of aggregate demand (AD) in an economy, there is a shift of the entire AD curve

Diagram: Shift in Aggregate Demand (AD)

a-diagram-showing-a-shift-in-the-entire-aggregate-demand-ad-curve-a-level-economics-revision — **An increase in any of the determinants of AD will cause the AD curve to shift right - and vice versa**

Diagram analysis

An increase in any one of the determinants of aggregate demand (AD) results in a shift right of the entire curve from AD₁ → AD₂
- At every price level, real GDP has increased from Y₁ → Y₂
A decrease in any one of the determinants of AD results in a shift left of the entire curve from AD₁ → AD₃
- At every price level, real GDP has decreased from Y₁ → Y₃

The Determinants of Aggregate Demand

AD = Consumption (C) + investment (I) + Government Spending (G) + (Exports (X) - Imports (M))
Each of these components are influenced by a range of factors and any change to one of them has the potential to shift the aggregate demand curve
If numerous factors change at the same time, the net effect will determine which way—and how far—the aggregate demand shifts

Diagram: Factors that Affect each Determinant

When multiple factors change at the same time, the net effect will determine which way the AD curve shifts—and how far. It is easier to analyse the impact of a single change

The determinants of consumption

Consumption is the total spending on goods and services by consumers (households) in an economy
The level of disposable income that households have impacts the level of consumption
- Consumption increases as disposable income increases
- Consumption decreases as disposable income decreases

Factors that Cause a Change in the Level of Consumption

Factor	Explanation
Changes in interest rates	Interest rates are set by the government's Central Bank Changes to the base rate cause commercial banks to change the lending and saving rates they offer customers A change in interest rates will change the level of consumer spending and savings If interest rates increase there is a greater incentive to save More saving = less consumption If interest rates increase, the monthly repayment on any loan or mortgage increases Higher loan repayments = less consumption
Changes in consumer confidence	The stronger the economy, the higher consumer confidence Consumers feel secure in their jobs and are confident of receiving regular salary payments Consumption increases and saving decreases In a weakening or recessionary economy, consumer confidence falls Consumers feel less secure in their jobs Consumption decreases and saving increases
Changes in wealth	If consumer wealth increases, then consumption usually increases Rising property prices or share prices give consumers confidence to borrow more money Increased borrowing = increased consumption

The determinants of investment

Investment is the total spending on capital goods by firms
Investment helps to increase the capacity (production possibilities) of an economy
- Increased capacity = increased potential economic growth

The Factors that cause a Change in the Level of Consumption

Factor	Explanation
Business confidence	The longer the period of economic growth, the higher the business confidence will be If growth slows, future expectations of profits will decrease, and investment decisions will become harder
Changes in government intervention	Government intervention can increase investment e.g. subsidies Government regulation can decrease investment (it raises costs of production for firms and can lower profits)
Changes in interest rates	Most investment by firms is financed through business loans Decreasing interest rates encourage investment There is a mostly inverse relationship between investment and interest rates
Demand for exports	If demand for exports increases, firms will likely invest to meet the global demand Demand for exports can increase if the exchange rate depreciates as goods/services now seem cheaper to foreigners

The determinants of government spending

The level of government spending is influenced by the economic cycle, the political agenda, and the planned level of capital spending

The Factors that Influence Government Spending

Factor	Explanation
Economic cycle	Governments will spend more in a recession to stimulate the economy and less during times of inflation Unemployment decreases with a booming economy, leading to a lower level of means-tested benefit payments, and vice versa Tax revenue increases with a booming economy and can be used to pay back government debt or increase expenditure on public/merit goods - and vice versa
Political decisions	Political decisions made to gain popularity often involve increasing spending to secure votes
Capital spending	National capital investments such as building roads and railways Government expenditure can happen on a local level (e.g., Kent County Council) or a national level (central government)

The determinants of net exports

The net trade balance is the difference between the value of the exports and imports (X-M)
The net trade balance is influenced by changes to real income, exchange rates, and the degree of protectionism

Factors Impacting Exports & Imports

Factor	Explanation
Exports levels	The higher the incomes abroad, the higher the demand for exports If inflation rate of UK is lower relative to trading partners, the higher the demand for UK exports If UK sterling depreciates in value, exports are less expensive for foreigners; exports increase An increase in protectionism (regulation, tariffs) would lead to retaliation from other countries and demand for exports would fall
Import levels	Level of income of UK residents increases, demand for imports increases If inflation rate of UK is lower relative to trading partners, the lower the demand for UK imports If sterling appreciates in value, then consumers’ income goes further abroad and demand for imports increases An increase in protectionism (regulation, tariffs), would lead to decreased demand for imports as they are more expensive

Factor

Explanation

Exports levels

The higher the incomes abroad, the higher the demand for exports
If inflation rate of UK is lower relative to trading partners, the higher the demand for UK exports
If UK sterling depreciates in value, exports are less expensive for foreigners; exports increase
An increase in protectionism (regulation, tariffs) would lead to retaliation from other countries and demand for exports would fall

Import levels

Level of income of UK residents increases, demand for imports increases
If inflation rate of UK is lower relative to trading partners, the lower the demand for UK imports
If sterling appreciates in value, then consumers’ income goes further abroad and demand for imports increases
An increase in protectionism (regulation, tariffs), would lead to decreased demand for imports as they are more expensive

Last updated: 14 October 2024

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