The characteristics of AD

A) Components of AD: C+I+G+(X-M)

Aggregate demand is the total demand for goods/services within an economy. When there is an increase in AD, there is an increase in economic growth. There are four main components of Aggregate demand that students need to learn:

  • Consumer spending –The total spending on goods/services by consumers within the economy.


  • Investment – The total spending by firms on capital goods within the economy. The effect of this is an increase in the productive capacity of the economy thus increasing long run economic growth, as the quantity and quality of factors of production increase. In However, in the short run, investment causes an increase in aggregate demand.


  • Government spending – The total amount of money spent by the government within the economy. The majority of spending by the government is on pensions, healthcare and welfare payments.


  • Net trade (X-M) – The difference between export revenue and the money spent on imported goods/services.


All these components measure the total amount of spending within the economy, which gives the measurement of the total demand within the economy and therefore provides a measurement of economic growth.


B) The relative importance of the components of AD

The most important component of AD is consumer spending. This makes up around 60% of the AD figure. Therefore, factors effecting consumption such as interest rate changes can have a big impact on the overall AD value and therefore economic growth. The next biggest component of AD is government spending which makes up around 25% of AD. Governments often use this influence in times of economic downturn by spending large amounts of money in an attempt to increase AD. An example of this was during the time of the global financial crisis where government debt as a percentage of GDP increased by around 30%. Investment makes up around 15% of AD, whereas net trade only makes up around 1% of AD. This is one of the reasons why some countries such as the UK decide to ignore their current account deficit, as the effect it has on AD is minimal. For example, a 1% increase in consumption would have a much bigger effect on the economy than a 1% increase in net trade.


C) The AD curve

AD curve

Aggregate demand is downwards slopping for three main reasons:

The wealth effect – This occurs when there is a fall in price level, giving consumers the perception that they are wealthier as the purchasing power of money increases (assuming wages stay the same). This means that a fall in the price level encourages consumers to spend more, thus increasing Real GDP.

Increased export revenue – A decrease in the general price level of goods/services within an economy will make exports cheaper (assuming that the price of international goods/services doesn’t decrease also). AS a result of this, lower price levels cause export revenue to increase and therefore Real GDP to increase.

Lower interest rates – As the price level/inflation decreases interest rates usually fall also. This encourages consumer consumption and investment to increase. Therefore, as these components increase, so does Real GDP.


D) The distinction between a movement along, and a shift of, the AD curve

AD movements

As the general price level decreases from P1 to P2, Real GDP increases from Y1 to Y2.

Aggregate demand shifts

As AD shifts outwards (AD1 to AD2), Real GDP (the value of economic output) increases (Y1 to Y2). On the other hand, when AD shifts inwards (AD1 to AD3), Real GDP decreases (Y1 to Y3).


Overall, a change in the general price level of goods/services within an economy will cause a movement along the AD curve, whereas a change in the value of the components of AD will cause AD to shift. The factors causing a shift in AD will be explained throughout the topic of Aggregate Demand as the components are broken down into their own topics (2.2.2 Consumption, 2.2.3 Investment, 2.2.4 Government expenditure and 2.2.5 Net trade).