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

A diagram showing the aggregate demand (AD) curve for an economy with Average Price Level on the Y axis and Real GDP on the X axis

• 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

A diagram showing an increase and decrease in the average price level (AP) which causes a movement along the aggregate demand (AD) curve leading to a contraction/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

A Shift of the Entire AD Curve

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

A diagram showing a shift in the entire aggregate demand (AD) curve due to a change in one of the determinants of AD

Diagram Analysis

• An?increase?in any one of the?determinants ofaggregate 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