IB ECONOMICS

3.5 Aggregate Demand

 In macroeconomics, aggregate demand (AD) is the
total demand for final goods and services in an
economy at a given time. It specifies the amounts
of goods and services that will be purchased at all
possible price levels. This is the demand for the
gross domestic product of a country.

 Topics:

 ​The aggregate demand curve

 Determinants of aggregate demand

 Shifts of the aggregate demand curve

Introduction
• Distinguish between the microeconomic concept of the level of corporate indebtedness.
demand for a product and the macroeconomic concept
of aggregate demand. • Explain how the AD curve can be shifted by changes
in government spending due to factors including
• Construct an aggregate demand curve. political and economic priorities.

• Describe consumption, investment, government • Explain how the AD curve can be shifted by changes
spending and net exports as the components of in net exports due to factors including the income of
aggregate demand. trading partners, exchange rates and changes in the
level of protectionism.
• Explain how the AD curve can be shifted by changes
in consumption due to factors including changes in
consumer confidence, interest rates, wealth, personal
income taxes (and hence disposable income) and level
of household indebtedness.
Learning Objectives
• Explain how the AD curve can be shifted by changes
in investment due to factors including interest ​rates,
business confidence, technology, business taxes and
 Aggregate Demand
1 2 3
Individual demand is the total A price level is the current weighted * The demand from consumers
number of goods and service that average price of a representative (Consumption)
an individual is willing and able to selected group of goods and services
buy at a range of prices. (such as that found in the consumer * The demand from firms
price index or CPI) produced in an (Investment)
Market demand is the sum of all economy in a specified period of time
total number of goods or services * The demand from government
(typically one year). (Government)
that all consumers in a market for
a particular good or service is We can think of aggregate demand as * The demand for exports from
willing and able to buy at a range the total demand for all goods and foreign buyers (Exports)
of prices. services in all the different markets for
goods and services within an economy; * Less, the demand for imports
Aggregate demand is best i.e., it is the sum of all demand within a (Imports)
defined as being the total quantity country. However, aggregate demand is
of all output (real GDP) that all not just all consumer demand, it is the
buyers in a given economy are demand from all buyers in an economy;
willing and able to buy at all namely:
possible price levels.
COMPONENTS OF Aggregate Demand AD
INTERNATIONAL TRADE
PRICE LEVEL
Aggregate Demand Explained
 THE AGGREGATE DEMAND CURVE
The aggregate demand curve (shown below) is a model of the relationship
between the total demand from all four components (C + I + G + X-M)
of aggregate demand and the price level of an economy (e.g., the CPI)
with a given time period (e.g., one year). There is a negative relationship
between aggregate output and the price level and this is why the AD curve
slopes downward and to the right.

AD = C + I + G + X - M
 The determinants of AD
1
The aggregate demand curve may
shift to the right (an increase in AD)
or to the left (a decrease in AD). It is
important to distinguish between
movements along the AD curve
(e.g., due to the wealth effect) and
shifts of the AD curve. Only
changes in the determinants of
aggregate demand (C + I + G + X –
M) will shift the AD curve.
Shifts of the AD Curve
CONSUMPTION
EXPENDITURE
 Consumption expenditure
1 2 3
Consumption. This is made by Factors that affect consumption: 2. Interest rates
households, and sometimes
consumption accounts for the larger Lower interest rates tend to increase
portion of aggregate demand. An consumption because larger goods
1. Consumer confidence are usually purchased on credit and
increase in consumption shifts the
AD curve to the right. If consumers are confident about their if interest rates are low, then it’s
future income, job stability, and the cheaper to borrow. Consumers
economy is growing and stable, spending is mostly borrow to buy houses, which
likely to increase. However, any job is one of the biggest purchases and
insecurity and uncertainty over income is lower interest rates means lower
likely to delay spending. An increase in mortgage payments, so households
consumer confidence shifts AD to the right. can spend more on other goods.
Some Economists argue that lower
interest rates also make saving less
attractive, but there is no real
evidence. So, lower interest rates
increase Aggregate Demand.
 Consumption expenditure
4 5 6
3. Consumer debt 5. Changes in personal income
taxes
If a consumer has a lot of debt, he is
unlikely to buy more since he would Personal income taxes are taxes paid
have to pay his debt off first. Low by households on the incomes they
consumer debt increases earn. Any increase in personal
consumption and aggregate demand. income tax will decrease the
disposable income of consumers
(i.e., their after tax income) and
4. Wealth thus, spending decreases. The
opposite occurs if governments
Wealth are assets held by a reduce personal income taxes –
household, such as property or disposable income increases and
stocks. An increase in property is consumer spending increases..
likely increase to consumption.
INVESTMENT
EXPENDITURE
 Investment. Investment,
second of the four
components of aggregate
demand, is spending by
firms on capital, not
households. Investment is
the most volatile
component of AD. An
increase in investment
shifts AD to the right in the
short run and helps improve
the quality and quantity of
factors of production in the
long run.
 Investment Expenditure
1 2 3
Factors that affect investment: 3. Investment policy 4. Business taxes

1. Interest rates If governments provide incentives such Governments may choose to tax the profits of
Firms borrow from banks to make as tax breaks, subsidies, loans at lower businesses (business income taxes or
large capital intensive purchases, and interest rates then investment can corporate taxes), and they can increase or
if the interest rate decreases, it increase. However, corruption and decrease these taxes on businesses. Any
becomes cheaper for firms to invest bureaucracy deters investment. increase in business taxes will lead to a lower
and provides incentive for firms to level of investment spending by firms,
Technology because, all things being equal, an extra
take risk.
Technological improvements lead to dollar spent on taxes is a dollar that could
2. Business confidence greater investment spending as firms have been spent on investment. Vice versa
adopt new technologies to make them for decreases in the corporate tax rate.
If firms are confident about the
economy and its future growth, they more productive and/or more
are more likely to invest in capital, competitive in their markets.
new projects and buildings/machinery.
 Investment Expenditure
4
5. Level of corporate indebtedness

Similar to consumer indebtedness, if

firms have borrowed a lot in general
to finance their investments then they
are less likely to engage in additional
borrowing to finance further
expansion. Thus increase in the debt
accumulated by firms in the economy
will lead to a decrease in AD, and
decrease in the debt of firms will
cause AD to increase and shift right.
GOVERNMENT SPENDING
 Government spending
1 2 3
Government spending forms a large
total of aggregate demand, and an
increase in government spending
shifts aggregate demand to the right.
Different governments may have
different priorities, both political and
economic. Government spending is
categorised into transfer payments and
capital spending. Transfer payments
include pensions and unemployment
benefits and capital spending is on
things like roads, schools and
hospitals. Governments spend to
increase the consumption of health
services, education and to re-distribute
income. They may also spend to
increase aggregate demand. 
 IMPORTS, EXPORTS
AND EXCHANGE RATES
Imports, Exports and Exchange rates
NET EXPORTS
 1. Net exports. Imports are
foreign goods bought by
consumers domestically, and
exports are domestic goods
bought abroad. Net exports is
the difference between exports
and imports, and this
component can be net imports
too, if imports are greater than
exports. An increase in net
exports shifts aggregate
demand to the right. Changes
in national income abroad,
the exchange rate and trade
policy affects net exports.
 Net exports
1 2 3
2. Changes in the national income of 3. Trade protection Increases and decreases in trade
trading partners In economics, protectionism protectionism affect aggregate demand.
is the economic policy of Take for example, if country A imposes a
Most countries will have major export restraining trade between trade tariff on country B’s goods (which
markets. These are overseas markets countries through methods they import) in a bid to “protect” its
which purchase a relatively large such as tariffs on imported domestic produce and make it more
proportion of a country’s exports. For goods, restrictive quotas, and competitive (assuming that they are in
example, China is the largest destination a variety of other government competitive demand), the imports coming
for New Zealand exports, and Germany regulations.   from country B will become more
exports more to France than to any other expensive. Consumers will switch away
country. As national incomes in key export from buying those imports to buying the
destinations increase, all things being locally produced good (for country A this
equal, demand for all products in these is good because consumption of domestic
markets increases, including exports. good increase causing their aggregate
Economic recessions in major export demand to increase). Country B’s export
markets will see a decrease in demand for revenue falls and this results in a fall in
a nation’s exports and aggregate demand country B’s aggregate demand.
will decrease as export receipts fall.
 Net exports
4 5 6
4. Exchange rates Exchange rates surface as an An appreciation (increase) of the
An exchange rate is the price of one aggregate demand exchange rate, that is, the price of buying
currency in terms of another, the rate at determinant because they foreign currency in terms of domestic
which one currency can be exchanged for effect the relative prices of currency increases, causes a decrease in
another. For example, the exchange rate imports and exports, and thus net exports and an decrease in aggregate
between U.S. dollars and British pounds is the net exports component of demand.
the price of buying one British pound in aggregate expenditures.
terms of the amount of U.S dollars paid. When exchange rates change, A depreciation (decrease) of the
the relative prices of exports exchange rate, that is, the price of buying
and imports also change, foreign currency in terms of domestic
which causes exports, currency decreases, causes an increase in
imports, net exports, and thus net exports and an increase in aggregate
aggregate demand to change. demand.
 Net exports
7 8 9
In terms of an appreciating exchange On the other side of the net With imports falling and exports
rate, if for example the UK pound export equation, British rising, net exports unquestionably
and the US dollar previously traded consumers pay less for goods increase. And with this increase in
at US$2.00 to the UK pound, and it purchased from US producers net exports goes an increase in
now trades at US$2.50 per pound. (that is, imports). An aggregate demand. The higher
This higher exchange rate means that American publisher selling exchange rates cause an increase in
US consumers pay more for any books into the UK market for aggregate demand, which is a
goods purchased from British US$20 costs British rightward shift of the aggregate
producers (that is, imports). A consumers £10 at the original demand curve. 
British-made car selling for 10,000 exchange rate and £8 at the
British pounds in Britain costs U.S. new exchange rate. At this ​ he opposite occurs with a
T
consumers $20,000 at the original lower price, British depreciating exchange rate. 
exchange rate and $25,000 at the consumers are bound to buy
new exchange rate. At this higher more American-made
price, US consumers are bound to products, causing US imports
buy fewer British-made products, to the UK to increase.
causing UK exports to decline.
AGGREGATE DEMAND:
PRACTICE
Aggregate demand: Practice