Chapter 14 - Aggregate Demand

May. 5 Pages 223-233

What aggregate demand (AD) is

● Aggregate demand is the total spending on goods and services in a period of time at a
given price level
○ It appears much like a downward sloping demand curve
● Along the y-axis, where microeconomics has “price” of one good, macroeconomics has a
measure of the average price level of all goods and services
● Where the microeconomic demand curve has the “quantity” of one good on the x-axis,
macroeconomics has the total quantity of all goods and services
○ In macroeconomic analysis, the x-axis is commonly referred to as “real output”
● The aggregate demand curve shows the relationship between average price level and
real output

Components of aggregate demand

● Consumption is the total spending by consumers on domestic goods and services

○ Consumer demand looks at both:
○ Durable goods
■ Goods that are used by consumers over a period of time ( > 1 year)
○ Non-durable goods
■ Goods that are used up immediately or over a relatively short period of
time
● Investment is defined as the addition of capital stock to the economy
○ The two types of investment firms have are:
○ Replacement investment, which occurs when firms spend on capital in order to
maintain productivity of their existing capital
○ Induced investment, which occurs when firms spend on capital to increase their
output to respond to higher demand in the economy
● Government spending occurs when governments spend at a variety of levels levels on
a wide range of goods and services
○ The amount depends on policies and objectives of the government
● Net exports (X - M)
○ Exports are domestic goods and services that are brought by foreigners
○ The net trade component of AD is actually export revenues minus import
expenditure, but it is noted as exports minus imports (X - M)
 ○ If the net figure is positive, it will add to AD but if the figure is negative, it will
reduce AD

AD = consumption + investment + government spending + net exports = GDP (using

expenditure method of calculation)

Shape of the AD curve

● It can be presented as the formula C + I + G + (X - M), where a decrease in price causes

the level of output of the components in this equation increase, and vice versa
● It can also be presented as a diagram

The causes of change in AD

● A change in price level will result in a movement along the AD curve

● A change in any of the other components of aggregate demand will cause a shift in the
demand curve

The causes of change in consumption

● Changes in income taxes
○ As incomes rise, people have more money to spend on goods and services so
consumption increases
○ In increase in direct income taxes, causes less disposable income, wich results in
a decrease of consumption and a fall in AD
● Changes in interest rates
○ If there is an increase in interest rates, which is essentially the price of borrowed
money, then there is likely to be borrowing
■ Therefore, consumption will fall, resulting in a fall in AD
○ An increase in interest rates leads to a fall in consumption, and vice versa,
ceteris paribus
● Changes in wealth
○ The amount of consumption depends on the amount of wealth that consumers
have
○ The two main factors that change levels of wealth are
■ A change in house prices
■ A change in the value of stocks and shares
● Changes in consumer confidence/expectations
○ If people aare optimistic about their economic future then they are likely to spend
more
○ Economists regularly measure consumer confidence and put the information
together in the form of indexes
 ■ An increase in the index indicates that confidence is rising
○ If consumers expect the price level to increase in the future, ie inflation, then they
will increase consumption at that moment, especially on durable consumer goods
● Levels of household indebtedness
○ The extent to which households are willing and able to borrow money affects
consumption
○ If it is easy to borrow money and interest rates are low, then it is likely that
households will take on more debt by getting loans or using their credit cards
○