Aggregate Demand

About aggregate demand

Similar to the expenditure method, aggregate demand (AD) refers to the total level of spending in the economy. In general, aggregate demand includes:

• Household spending (C)

• Investment by businesses and households (I)

• Spending by the government (G)

• Net spending from overseas (X-M)

Aggregate demand components

Consumption

• Refers to spending by households on things like rent, groceries and utilities.

• Make up the largest share of aggregate demand.

• Largely dependent on the level of household income and household wealth.

Investment

• Refers to spending by businesses and households that increase the economy’s capacity to produce additional goods and services.

• Including building houses and offices, purchasing machinery, constructing roads and other infrastructure and so on.

• Influenced by a range of factors such as interest rates, expected profits, government policy and changes in technology.

Government spending

• Government spending can be either cyclical or structural.

• Structural spending such as spending on education, health services and defence occurs regardless of the state of the economy.

• Other spending is more cyclical such as the government spending to support the unemployed due to an economic downturn.

Net exports

• Net exports = Spending on exports – spending on imports.

• Exports refer to goods and services that are sold to other businesses, households and governments overseas.

• Imports are goods and services that are bought from overseas.

Aggregate demand curve

Movement along the aggregate demand (AD) curve

Put simply, the aggregate demand (AD) curve is a graphical representation of aggregate demand.

Contraction in AD

AD curve slopes downward because:

• As the price is lower, people’s disposable income is higher, and they can consume more goods and services.

• At a lower price level, interest rates usually fall, encouraging borrowing and investment.  

• When the output prices fall, exports are relatively more competitive than imports, which boosts net exports.

Expansion in AD

Likewise, if the overall price level in the economy increases, this results in an upward movement along the AD curve.

• As prices rise, the real value of household wealth decreases, reducing consumption.

• Higher prices often lead to higher interest rates, making borrowing more expensive and reducing investment and consumption.

• Higher domestic prices make exports more expensive for foreign buyers, reducing demand for exports and increasing demand for imports, which lowers net exports.

Shifts in aggregate demand (AD) curve

Without a change in the price level, a shift in the aggregate demand (AD) curve occurs when there is a change in one of the components of aggregate demand:

• Consumption (C)

• Investment (I)

• Government spending (G)

• Net exports (X-M)

Increase in AD

An increase in AD (shift to the right of the curve) could be caused by a variety of factors:

i) Increased consumption (C)

• An increase in consumers wealth (e.g. higher house prices)

• Lower interest rates (cheaper borrowing and investment costs)

• Higher wages

• Lower taxes

• Increased consumer optimism about the future

ii) Increased investment (I)

• Lower interest rates

• Increased business confidence in the economic outlook

• Improved technology

• Increased economic growth

iii) Increased government spending (G)

• Government pursues expansionary fiscal policy

• Increased government expenditure on infrastructure, defence or public services

iv) Increased net exports (X-M)

• A depreciation of domestic currency makes exports cheaper, thus increasing net exports

• Increased growth in other trading partners, increasing demand for exports

Fall in AD

A decrease in AD (shift to the left of the curve) could be caused by a variety of factors:

v) Decreased consumption (C)

• A decrease in consumers wealth (e.g. lower house prices)

• Higher interest rates (cheaper borrowing and investment costs)

• Lower wages

• Higher taxes

• Decreased consumer optimism about the future

vi) Decreased investment (I)

• Higher interest rates

• Decreased business confidence in the economic outlook

• Economic slowdown

vii) Decreased government spending (G)

• Government pursues contractionary fiscal policy

• Reduced government expenditure on infrastructure, defence or public services

viii) Decreased net exports (X-M)

• An appreciation of domestic currency makes exports more expensive, thus reducing net exports

•  Economic contraction in other trading partners, reducing demand for exports

References

Brown, T & Foreman, C 2022, UH Macroeconomics 2022, OpenStax, Houston, TX, pp. 457-527.

Econlib n.d., Aggregate Demand, Econlib, available at <https://www.econlib.org/library/Topics/College/aggregatedemand.html>.

Reserve Bank of Australia n.d., Economic Growth, Reserve Bank of Australia, available at <https://www.rba.gov.au/education/resources/explainers/economic-growth.html>.

Will, K 2024, Aggregate Demand: Formula, Components, and Limitations, Investopedia, available at <https://www.investopedia.com/terms/a/aggregatedemand.asp>.