Economics Online Tutor
Aggregate Demand Curve
Aggregate demand is the total of all expenditures in the economy. Total
expenditures in the AD/AS model equal real GDP. Using the expenditures
approach, GDP equals the sum of consumption (household sector),
investment (business sector), government purchases (government sector),
and net exports (international sector). The factors of aggregate demand are
the factors that influence spending by each of these sectors:
Household sector: the factors of household consumption are income,
wealth, expectations, demographics, and taxes.
Income: an increase in income will increase consumption.
Wealth: an increase in wealth will increase consumption.
Expectations: consumer confidence influences consumption. If consumers
are confident that income and wealth will increase in the future, current
consumption will rise. If consumers fear a job loss or a recession, current
consumption will fall.
Demographics: total population and age distribution affect consumption. An
increase in the total population will increase consumption. Older and
younger households tend to spend more and save less (higher MPC) than
households in the middle of the age groups.
Taxes: the amount of taxes helps determine the level of disposable income,
and therefore influences the amount of consumption spending.
The difference between
income and wealth:
Income is the amount of
money and other assets
acquired during a
specific time frame. In
the framework of the
concept of stocks and
flows, income is a flow.
Wealth is the value of
assets owned at a
specific point in time. In
the framework of stocks
and flows, wealth is a
Business sector: the level of business investment depends on the
profitability of investments, which depends on interest rates, technology,
the cost of capital goods, and excess capacity.
Interest rates: a large portion of investment is financed through borrowing.
Interest is the cost of borrowing. The level of investment is inversely
related to the interest rate.
Technology: new technology increases investment. Firms change to new
methods in order to remain competitive.
The cost of capital goods: an increase in the cost of production reduces
profits. Lower profit potential will reduce investment spending.
Excess capacity: output can be increased without new investment if excess
capacity exists. More excess capacity in the economy means a lower level of
Government sector: government purchases increase aggregate demand by the amount of the
purchases. In addition, government purchases add money to the economy which is then subject to a
multiplier effect. The multiplier effect for government purchases is greater than the multiplier effect for
household income, since households have an MPC that is less than one (they will save a portion of
income instead of spend it). The money that the government adds to the economy through government
purchases may increase the price level. The level of government spending is often the result of
discretionary fiscal policy.
International sector: exports increase aggregate demand, imports decrease aggregate demand. The
level of exports depends on factors in the rest of the world. The level of imports is determined by
domestic factors. These factors are income, prices, exchange rates, and government policy.
Income: a portion of consumption will be for goods from the rest of the world. When foreign incomes
rise, exports increase. When domestic incomes rise, imports increase.
Prices: when the prices of domestic goods change relative to the prices of foreign goods, net exports
will change. Higher domestic prices will increase imports. Higher foreign prices will increase exports.
Exchange rates: when the domestic currency depreciates on the foreign exchange market, domestic
goods become cheaper to foreign buyers and exports will increase. Imports will decrease at the same
time because the change in the exchange rate will make foreign goods more expensive for domestic
Government policy: trade restrictions imposed by governments limit the amount of exports and/or
These factors of aggregate demand include both price factors and non-price factors. Changes in the
price factors will cause a cause a movement along the AD curve. Changes in the non-price factors will
cause a shift in the entire AD curve. This distinction is due to the fact that the price level is plotted
along the vertical axis.
Price factors of aggregate demand
Price factors of aggregate demand are divided into three categories: the wealth effect, the interest rate
effect, and the international trade effect. A change in any of these categories will cause a movement
along the AD curve.
Wealth effect: financial assets (money, stocks, and bonds) represent purchasing power. This
purchasing power changes inversely with changes in the price level. With any given amount of financial
assets, the higher the price level, the lower the purchasing power, and therefore the lower the real
Interest rate effect: as the price level increases, more money is needed for purchases. This increases
the demand for money, and lowers the demand for other financial assets such as bonds. A lower
demand for bonds will decrease the price of bonds, increasing interest rates. Higher interest rates will
create a decrease in aggregate investment spending.
International trade effect: changes in the relative prices of foreign and domestic goods will cause
changes in net exports. These are changes in the overall price level, creating a movement along the AD
These price factors of aggregate demand give the ad curve its downward slope.
Non-price determinants of aggregate demand
The price factors of aggregate demand (wealth effect, interest rate effect, and international trade
effect) show different real GDP levels at different price levels. Changes in all of the factors that affect
consumption, investment, government purchases, and net exports can also cause real GDP to change
at every price level. All factors of aggregate demand, then, are also non-price factors of aggregate
demand. Changes in the non-price factors of aggregate demand will cause the entire AD curve to shift.
|This page, along with additional commentary, was posted on the "Economics
Online Tutor" Facebook page's timeline on September 3, 2012.
You can now purchase your own
copy of the information from this
website in paperback or ebook
These book formats have the title
“Basic Economics for Students
and Non-Students Alike”, by
Jerry Wyant (that’s my name). The
price of the paperback is US$9.99, the
ebook is US$4.99.
You can find the paperback at amazon.
You can find the ebook at amazon.com or
at smashwords.com, as well as other