The Characteristics of Aggregate Demand (Edexcel A Level Economics A)
Revision Note
Written by: Steve Vorster
Reviewed by: Jenna Quinn
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:
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
The wealth effect: As AP increases, the purchasing power of households decreases and the AD falls - and vice versa
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
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