Every pound, dollar or rupee spent on a country’s output is spent by one of four groups: households, firms, the government, or foreigners. Add all that spending together and you have aggregate demand. Once you can see AD as four buckets of spending, almost every macro question becomes “which bucket changed, and why?”
📚 What you need to know
Aggregate demand (AD) is the total spending on a country’s goods and services at each average price level, over a period of time.
AD = C + I + G + (X − M) — consumption, investment, government spending and net exports.
The AD curve is downward sloping: a higher average price level goes with less total spending.
A change in the price level moves you along AD. A change in anything else shifts the whole curve.
Consumption is usually the biggest component, so a small percentage change in C moves AD far more than the same change in net exports.
AD shifting right means more spending at every price level; AD shifting left means less.
What aggregate demand really means
“Demand” in micro is about one product. Aggregate demand is about everything an economy produces, all at once. Because you cannot add cars to haircuts to hospital beds, we measure AD in money: the total value of planned spending on domestic output.
Notice the word planned. AD is what buyers want to buy at each price level, not what actually gets produced. Where AD meets aggregate supply, you get the actual output of the economy — that comes later in this topic.
The aggregate demand equation
AD = C + I + G + (X − M)
The four components
Each letter is a different buyer. Keeping them separate matters, because different policies hit different letters.
The shares are rough and they differ a lot between countries — government spending is closer to half of AD in Sweden. Always use the figures given in the exam data, not memorised ones.
Why the shares matter. If consumption is 60% of AD and net exports are 1%, then a 10% rise in consumption adds about 6% to AD, while a 10% rise in net exports adds about 0.1%. That is why governments worry so much about consumer confidence.
Component
Who is spending
Watch out for
Consumption (C)
Households buying goods and services
Buying a second-hand car is not new output, so it is not counted
Investment (I)
Firms buying capital — machines, factories, software, stock
Buying shares is not investment in economics
Government spending (G)
The state paying for teachers, roads, defence, hospitals
Transfer payments such as pensions are excluded — no output is bought
Net exports (X − M)
Foreigners buying our goods, minus what we buy from them
This can be negative, which pulls AD down
Transfer payments trip students up every year. When the government pays a pension, no new good or service is produced at that moment. It becomes part of AD later, once the pensioner spends it — and then it counts as C, not G.
Why the AD curve slopes down
Most notes just say “it slopes down”. Examiners like the reason. There are three, and they are all about a rising average price level:
The wealth effect. Higher prices mean your savings buy less. You feel poorer, so you spend less — C falls.
The interest rate effect. Higher prices push central banks to raise interest rates. Borrowing costs more, so households delay big purchases and firms delay projects — C and I fall.
The international trade effect. If our prices rise while other countries’ prices do not, our exports look expensive and imports look cheap — X falls, M rises, so (X − M) falls.
All three push in the same direction, which is why the curve is fairly steeply downward sloping.
Movement along AD vs a shift of AD
This is the single most common diagram error at SL and HL. Ask one question: did the average price level cause the change, or something else?
Price level changed → movement along the curve (an extension or contraction of AD).
Anything else changed → the whole curve shifts left or right.
Draw the arrow on your diagram. Examiners award the mark for showing the direction of the shift, not just for a neat second line.
Income tax is cut, so households have more disposable income
Investment
Interest rates, business confidence, technology, corporation tax, corporate debt
The central bank cuts the base rate, so borrowing to buy machinery is cheaper
Government spending
Political priorities, the state of the economy, the budget
A new government commits to building rail links and hospitals
Net exports
Incomes of trading partners, the exchange rate, trade policy
The currency depreciates, so exports become cheaper for foreigners
Notice how often interest rates appear. One change in the base rate hits consumption and investment at the same time, which is exactly why central banks use it as their main tool.
Worked examples
WORKED EXAMPLE
Calculating AD from a data table
An economy reports the following for one year, in billions of dollars: consumption 620, investment 145, government spending 240, exports 190, imports 235, income tax revenue 180. Calculate aggregate demand.
Step 1: throw out what does not belongIncome tax revenue is not spending on output, so it is a distractor. Ignore it.Step 2: write the formulaAD = C + I + G + (X − M)Step 3: substituteAD = 620 + 145 + 240 + (190 − 235)AD = 1005 + (−45)AD = $960 billionNet exports were negative here, so trade pulled AD down by 45.
WORKED EXAMPLE
Shift or movement?
For each event, say whether AD shifts, and in which direction: (a) the average price level rises by 3%; (b) a housing boom makes households feel wealthier; (c) the main trading partner enters a deep recession.
(a) Price level risesNo shift.The price level is on the axis, so this is a movement up along the same AD curve — a contraction of AD.(b) Housing boomShift right.Higher wealth raises confidence and borrowing, so C rises at every price level.(c) Trading partner in recessionShift left.Their incomes fall, so they buy fewer of our exports. X falls, so (X − M) falls.Shift, movement, direction — state all three
💡 Exam tip
Label your axes properly: average price level on the vertical axis, real GDP (or real output) on the horizontal. “Price” and “quantity” will cost you the mark.
Always name the component that changed. “AD rises” is weak; “consumption rises, so AD shifts right” is what earns marks.
Use the size of each component in evaluation. A policy aimed at net exports simply cannot move AD as much as one aimed at consumption.
When a question gives you data, check for distractors like tax revenue, transfer payments or net income. They are put there on purpose.
Number your curves AD₁, AD₂ and add an arrow. Unlabelled shifts score nothing.
Interest rate changes affect C and I together — say both for a fuller answer.
⚠️ Common mix-up
“Investment” means buying shares. Not in economics. Investment is firms buying capital goods — machines, buildings, equipment.
Counting transfer payments in G. Pensions and benefits are not payment for output, so they are left out of G.
Confusing a movement with a shift. Only a change in the average price level moves you along the curve.
Forgetting the minus sign on imports. Rising imports reduce AD, because that money buys foreign output.
Saying AD is “how much is produced”. AD is planned spending. Output is decided where AD meets AS.
Assuming all components matter equally. They do not — use the percentage shares.
Up next: Short-Run Aggregate Supply — the other half of the model, and why the SRAS curve slopes upwards while firms’ costs are stuck.
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