Aggregate Demand Curve

The aggregate demand (AD) graph

The graph below shows a standard downward-sloping aggregate demand curve that demonstrates a movement along the curve. On the x-axis, we have the real GDP, which represents an economy's output. On the y-axis, we have the general price level (£) at which the output in the economy is produced.

Fig 1. - Movement Along Aggregate Demand Curve

Derivation of the aggregate demand curve

There are three reasons why the AD curve is downward sloping. Aggregate demand can only ever change if households’ consumption, firms’ investments, government spending, or net export spending increase or decrease. If the AD is sloping downward, the aggregate demand changes purely due to price level changes.

The wealth effect

The first reason for a downward-sloping curve is the so-called ‘Wealth Effect’, which states that as the price level decreases, the purchasing power of households increases. This means that people have more disposable income and are therefore more likely to spend on goods and services in the economy. In this case, consumption increases solely due to a price level decrease and there is an increase in aggregate demand otherwise known as an extension of AD.

The trade effect

The second reason is the ‘Trade Effect’, which states that if price level decreases, causing a depreciation in the domestic currency, exports become more internationally price competitive and there will be greater demand for exports. The exports will generate more revenue, which will increase the value of X in the AD equation.

Imports, on the other hand, will become more expensive because the domestic currency will depreciate. If the import volumes are to remain the same, there will be more spending on imports, causing an increase in the value of ‘M’ in the AD equation.

The overall effect on the aggregate demand due to a decrease in the price level via the trade effect is therefore ambiguous. It will depend on the relative proportion of export and import volumes. If the export volumes are larger than the import volumes, there will be an increase in the AD. If the import volumes are larger than the export volumes, there will be a fall in the AD.

Interest effect

The third reason is the ‘Interest Effect’, which states that if price levels were to decrease due to the rise of supply commodities relative to the demand of the commodities, the banks would also lower the interest rates for them to match the inflation target. Lower interest rates mean that the cost of borrowing money is lower and that there is a lower incentive to save money as borrowing has become easier for households. This would increase income levels and the consumption of households in the economy. It would also encourage firms to borrow more and invest more in capital goods such as machinery promoting economic activity contributing to an expansion of aggregate demand.

Aggregate demand curve shift

What affects the aggregate demand curve? The main determinants of AD are consumption from households (C), investments of firms (I), government (G) spending on the public (health care, infrastructure, etc.) as well as the spending on net exports (X - M).

If any of these determinants of aggregate demand, excluding the general price levels, change due to external reasons, the AD curve shifts either to the left (inward) or to the right (outward) depending on whether there has been an increase or a decrease in those components.

Keep in mind this formula.

\(AD=C+I+G+(X-M)\)

To summarise, if the determinants of consumption (C), investment (I), government spending (G), or net exports increase (X-M), independent of the price level, the AD curve will shift to the right.

If there is a decrease in any of these determinants, independent of the price level, then there will be a decrease in aggregate demand and a shift to the left (inward).

Let’s look at some examples:

Conversely, a fall in consumer confidence due to lower optimism; a fall in investments from firms due to higher interest rates with the banks setting a contractionary monetary policy; decreased government spending due to a contractionary fiscal policy; and increased imports are factors that will cause the aggregate demand curve to shift inward.

Aggregate demand diagrams

Let’s look at graphical examples for both cases of an increase in aggregate demand and a decrease in aggregate demand.

Increase in aggregate demand

Let’s say Country X enacts an expansionary fiscal policy to boost economic growth. In this scenario, the government of Country X would reduce taxes and increase spending on the public. Let’s see how this would affect the aggregate demand curve.

Fig 2. - Outward Shift

Since Country X has implemented the expansionary fiscal policy of reducing the taxation rates on households and businesses, and increasing overall government spending on the public sector in infrastructure and health care, we can deduce how that would affect the aggregate demand curve.

The government reducing tax rates for households would lead to consumers having a higher disposable income, and thus more money to spend on goods and services. This would make the aggregate demand curve (AD1) shift to the right and overall real GDP would subsequently increase from Q1 to Q2.

The businesses would also have to pay lower taxes and would be able to spend their money on capital goods in the form of investments in machinery or building new factories. This would encourage further economic activity as the firms would need to hire more labour to work in these factories and earn a salary.

Finally, the government would also increase spending on the public sector such as building new roads and investing in public health care services. This would encourage further economic activities in the country as more jobs were being created through these various projects. The price in this structure remains constant at P1, as a shift of the AD curve only occurs in events independent of price level changes.

Decrease in aggregate demand

Conversely, let’s say that the government of Country X enacts a contractionary fiscal policy. This policy involves raising taxes and reducing government spending to tackle the issue of inflation, for example. In this case, we would see a decrease in overall aggregate demand. Take a look at the graph below to see how that would work.

Fig 3. - Inward Shift

Based on the contractionary fiscal policy the government has enacted we will see increased taxation as well as decreased spending on the public sector. We know that government spending is one of the main components of aggregate demand, and a decrease in one of the components will cause the AD curve to shift inward.

Since taxation rates are higher, households will be less inclined to spend their money as most of it is being taxed by the government. Hence, we will see fewer households spend their money on goods and services, thus decreasing overall consumption.

Additionally, a business paying higher rates of taxes won’t be inclined to keep investing in more of their capital goods such as machinery and new factories, thus reducing their overall economic activity.

With overall investments from firms, consumption of households and spending from the government going down, the AD curve will shift inward from AD1 to AD2. Subsequently, the real GDP will decrease from Q1 to Q2. Price remains constant at P as the determining factor of the shift was the contractionary fiscal policy and not a price change.

Aggregate demand and the national income multiplier

Let’s take a scenario where the US government increases government spending by 8 billion dollars, but their tax revenue generated in that year remains the same (constant). The increase in government spending will result in a budget deficit and it will be injected into the circular flow of income. However, the increased government spending will lead to an increase in the income of households in the US.

Now, let’s assume that the households decide to save a fraction of the amount of their income that has increased and spend the rest of the money on goods and services.

The 8 billion dollars that the government has spent will generate smaller and successively smaller increases in households’ income until the income is so small that it can be ignored. If we add up these small successive stages of income, the total increase of income is a multiple of the initial spending increase of 8 billion dollars. If the size of the multiplier were to be 3.5 and the government spending 8 billion dollars in consumption, this would cause national income to increase by $28,000,000,000 billion (8 billion dollars x 3.5).

We can illustrate the effect of the multiplier on national income with aggregate demand and the short-run aggregate supply diagram below.

Fig 4. - Effect of a Multiplier

Let’s assume the previous scenario again. The US government has increased government spending on consumption by 8 billion dollars. Since ‘G’ (government spending) has increased, we will see an outward shift in the aggregate demand curve from AD1 to AD2, simultaneously raising price levels from P1 to P2 and real GDP from Q1 to Q2.

However, this increase in government spending will trigger the multiplier effect as households generate successively smaller increases of income, meaning that they have more money to spend on goods and services. This causes a second and greater outward shift in the aggregate demand curve from AD2 to AD3 simultaneously increasing real output from Q2 to Q3 and raising price levels from P2 to P3.

Since we have assumed that the size of the multiplier is 3.5, and the multiplier is the reason for a greater shift in the aggregate demand curve, we can conclude that the second increase in aggregate demand is three and a half times the size of the initial spending of 8 billion dollars.

Economists use the following formulas to find out the multiplier value:

\(Multiplier=\frac{\text{Change in national income}}{\text{Initial change in the government spending}}=\frac{\Delta Y}{\Delta G}\)

The different types of multipliers

There are numerous other multipliers in the national income multiplier related to each of the components of aggregate demand. With government spending, we have the government spending multiplier. Similarly, for investment, we have the investment multiplier, and for net exports, we have the export and import multiplier also referred to as the foreign trade multipliers.

The multiplier effect can also work the other way around, decreasing national income instead of increasing it. This happens when the components of aggregate demand such as government spending, consumption, investment, or exports decrease. It can also happen at times when the government decides to increase taxation on household income and business as well as when the country is importing more goods and services than exporting them.

Both of these scenarios show us a withdrawal from the circular flow of income. Conversely, increases in the components of demand, as well as lower tax rates and more exports, will be seen as injections into the circular flow of income.

Marginal propensity to consume and save

An individual can either consume or save their income, therefore,

\(MPC+MPS=1\)

The average MPC equals the ratio of total consumption to total income.

The average MPS equals the ratio of total savings to total income.

The multiplier formula

We use the following formula to calculate the multiplier effect:

\(k=\frac{1}{1-MPC}\)

Let’s look at an example for further context and understanding. You use this formula for calculating the value of the multiplier. Here ‘k’ is the value of the multiplier.

If people are willing to spend 20 cents of their income increase of $1 on consumption, then the MPC is 0.2 (this is the fraction of the income increase that people are willing and able to spend after taxation on imported goods and services). If MPC is 0.2, the multiplier k would be 1 divided by 0.8, which results in k being equal to 1.25. If government spending were to increase by $10 billion, the national income would increase $12.5 billion (the increase in aggregate demand $10 billion times the multiplier 1.25).

The accelerator theory of investment

The assumption here is that firms desire to keep a fixed ratio, also known as the capital-output ratio, between the output of goods and services they are currently producing and the existing stock of fixed capital assets. For example, if they need 3 units of capital to produce 1 unit of output, the capital-output ratio is 3 to 1. The capital ratio is also known as the accelerator coefficient.

If the growth of the amount of national output remains constant on a yearly basis, firms will invest the exact same amount of new capital each year to enlarge their capital stock and maintain their desired capital-output ratio. Hence, on a yearly basis, the level of investment remains constant.

If the growth of the amount of national output accelerates, investments from firms will also increase into their stock of capital assets to a sustainable level to maintain the desired capital-output ratio.

Conversely, if the growth of the amount of national output decelerates, investments from firms will also decrease into their stock of capital assets to maintain the desired capital-output ratio.