The Characteristics of Aggregate Demand (Edexcel A Level Economics A)

The Components of AD

• Aggregate demand (AD) is the total demand for all goods/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)

• If AD increases then economic growth has occurred and vice versa

• Consumption is the total spending on goods/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/services abroad and the expenditure on goods/services from abroad

  • Individuals, firms and governments export/import

The relative importance of the components of AD

• Depending on the country, the value of each component and its contribution to AD can vary significantly:

  • Government spending in Sweden is 53% of AD and in the UK, it is 25% of AD

• The % that each component contributes to AD in the UK is approximately

  • Consumption: 60%

  • Investment: 14%

  • Government spending: 25%

  • Net Exports: 1%

• A 1 % increase in consumption or government spending will have a much larger impact on economic growth than a 1% increase on net exports

The AD Curve

• The relationship between the average price level and the total output in an economy is shown with an aggregate demand (AD) curve

• The AD curve is downward sloping due to three reasons:

1. The interest rate effect: At higher average price (AP) levels, there are likely to be higher interest rates. Higher interest rates reduce investment and are an incentive for households to save - and vice versa

2. The wealth effect: As AP increases, the purchasing power of households decreases and the AD falls - and vice versa

3. The exchange rate effect: As AP falls, interest rates are likely to fall too. Lower interest rates lower the exchange rate. With a lower exchange rate, the economy's goods/services are more attractive abroad and exports increase, thereby increasing real GDP

A movement along the AD 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 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

A shift of the entire AD curve

• 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 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