Aggregate Demand (AD)

(Part 1)
with Marshal Padenga (PhD)
This session aims to…
• define aggregate demand (AD);
• understand its components;
• explain what causes AD to shift;
• draw AD curve;
• explain the importance of the multiplier.
Link to previous sessions
 aggregate demand (AD) links into national
income measurement (and the model of the
circular flow of income);
 the measure of AD is the same as that of the
expenditure method of GDP/National Income:
C + I + G + (X-M)
 as the expenditure method (E) = Output method
(O) = Income method (Y) then it also a measure
of those too.
Link to previous sessions cont’d...
 obviously, this means that if expenditure (and
AD) in the economy increases then the
economy will experience economic growth;
 this would be economic growth from the
“demand side” rather than from the “supply
side” (which is due to an increase in the
quantity or quality of factors of production).
Link to previous sessions cont’d...
 This obviously leads us to the question: do
increases in AS lead to increases in AD or do
increases in AD lead to increases in AS?
 This is a key question in the history of
economic thought;
 The answer depends on whether you think
free markets work well (like Adam Smith) or
that they require government intervention
(like Keynes).
Definition of aggregate demand
 aggregate demand is the total of all demand
or expenditure in the economy;
 Composition of AD:
 C= Consumption Spending;
 I = Investment Spending;
 G = Government Spending;
 (X-M) = difference between spending on
imports and receipts from exports;
(i.e. net exports or the Balance of Payments).
Formula for AD
this gives us a formula for aggregate demand (AD) of:
AD = C + I + G + (X-M)
The aggregate demand (AD) curve

P1

Ag
g re
g at
eD
P2 em
an
d
(A
1. a decrease in D)
the price level...

0 Y1 Y2
Real output
2. ...increases the quantity of
goods and services demanded
The aggregate demand (AD) curve
 the aggregate demand (AD) curve shows the
relationship between the price Level and the
level of real output or real expenditure or real
income (in other words “real GDP”) in the
economy.
Aggregate demand curve
 the vertical axis shows price level;
 price level is the average level of prices in the
economy;
this is measured by an index of price changes,
e.g. Consumer Price Index (CPI), Retail Price
Index (RPI), etc.;
 a rise in the price level is inflation.
Aggregate Demand
 the horizontal axis shows real output;
 real output is the total output in the economy
adjusted for inflation;
 real output is equal to real expenditure and
real income, i.e. real GDP.
Why is the aggregate demand curve downward sloping?
 the price level and consumption: the wealth effect;
 the price level and investment: the interest rate effect;
 the price level and net exports: the exchange rate effect.
Why is the Aggregate Demand Curve Is Downward Sloping? cont’d…
 the price level and consumption: the wealth (or “real balance”)
effect;
 a decrease in the price level makes consumers feel more
wealthy (the real value of their income increases), which in turn
encourages them to spend more;
 this increase in consumer spending means larger quantities of
goods and services demanded.
Why is the Aggregate Demand Curve Is Downward Sloping? cont’d…
 the price Level and investment: the interest rate effect;
 a lower price level reduces the interest rate, which
encourages greater spending on investment goods;
 this increase in investment spending means a larger quantity
of goods and services demanded.
Why is the Aggregate Demand Curve Is Downward Sloping? cont’d…
 the price level and net exports: the exchange rate effect;
 when a fall in the UK price level causes UK interest rates to fall,
the real exchange rate depreciates, which stimulates UK net
exports;
 the increase in net export spending means a larger quantity of
goods and services demanded.
Movements and shifts in AD curve
 a change in the price level will cause a
movement along the AD curve. higher prices
lead to a fall in AD;
 if there is a change in any of the other
variables (i.e. the components of aggregate
demand: C, I, G or (X-M)) it will cause a shift in
the AD curve.
Shifts in the aggregate demand curve
Average
price level

P1

AD2
AD1
0 Y1 Y2
Real output
Shifts in AD curve
Average
price level
(Due to: C, I, G, (X-M))

P1

AD2
AD1
AD3
0 Y3 Y1 Y2
(Due to: C, I, G, (X-M)) Real output
Why might the aggregate demand curve shift?
 the downward slope of the aggregate demand curve
shows that a fall in the price level raises the overall
quantity of goods and services demanded;
 many other factors, however, affect the quantity of
goods and services demanded at any given price level;
 when one of these other factors changes, the
aggregate demand curve shifts.
Why might the aggregate demand curve Shift? cont’d…
 shifts arising from:
 consumption (C);
 investment (I);
 government purchases (G);
 net exports (X-M).
Why might the aggregate demand curve Shift? cont’d…
 an increase in AD1 will cause a shift up to the right (AD2) and a
decrease in AD1 will cause a shift down to the left (AD3).
The AD curve and the multiplier
 as we know that:
AD = C+I+G+ (X-M);
 any increase in injections into the economy
(Investment, Government Spending or Net
Exports) will increase aggregate demand in the
economy and shift the AD curve to the right.
The AD curve and the multiplier cont’d...
 the multiplier is the figure used to multiply the
amount of increase in these injections to find
the final increase in national income (GDP);
 the multiplier effect means that any increase in
any of these injections will lead to an even
greater increase in aggregate demand and
national income.
The AD curve and the multiplier cont’d...
 so the bigger the size of the multiplier, the greater
the shift in the AD curve to the right
 in the diagram below the multiplier is larger in the
case of the shift to AD3 than it is in the shift to AD2
The multiplier and shifts in AD curve
Average (multiplier is 3) (multiplier is 5)
price level Assuming an equal
increase in
injections both
cases (e.g. An
increase in G of
£1bn)

P1

AD3

AD2
AD1
0 Y1 Y2 Y3
Real output
Are you now able to…
• define aggregate demand (AD);
• understand its components;
• explain what causes AD to shift;
• draw AD curve;
• explain the importance of the multiplier.
The end...

Thank you.