Aggregate Demand Components

Why This Matters

The aggregate demand equation—$AD = C + I + G + NX$—isn't just a formula to memorize; it's the foundation for understanding how economies expand, contract, and respond to policy interventions. Every time you analyze fiscal policy, monetary policy, or international trade effects on the AP exam, you're tracing how a change works through one or more of these components to shift the AD curve. The exam loves asking why AD shifts, not just that it shifts, so you need to understand the transmission mechanisms: the wealth effect, the interest rate effect, the exchange rate effect, and how each component responds to different economic conditions.

Here's what separates a 3 from a 5: knowing that a tax cut doesn't directly shift AD—it works indirectly through consumption. Knowing that investment is the most volatile component because it depends on business expectations. Knowing that net exports can offset domestic policy effects in an open economy. Don't just memorize the four components—understand what drives each one and how they interact with the price level, interest rates, and the broader AD-AS model.

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The Core Components of AD

The aggregate demand curve represents total spending in an economy at each price level. It's built from four distinct sources of spending, each with its own determinants and sensitivities.

Consumption (C)

• Largest component of AD—typically accounts for about 70% of total spending, making it the dominant driver of economic activity
• Driven by disposable income—as households earn more after taxes, they spend more; the marginal propensity to consume (MPC) measures how much of each additional dollar gets spent
• Sensitive to wealth and expectations—consumer confidence, asset prices, and interest rates all influence whether households spend now or save for later

Investment (I)

• Most volatile AD component—business spending on capital goods swings dramatically with economic expectations, making it a key driver of business cycles
• Interest-rate sensitive—higher real interest rates increase borrowing costs, reducing planned investment; this is the interest rate effect in action
• Includes three categories—business fixed investment (equipment and structures), residential construction, and inventory investment

Government Spending (G)

• Direct impact on AD—unlike taxes, government purchases of goods and services add directly to aggregate demand without requiring a behavioral response
• Policy-determined, not income-driven—spending levels reflect fiscal policy choices rather than automatic responses to economic conditions
• Carries a larger multiplier than taxes—the government spending multiplier exceeds the tax multiplier because every dollar spent enters the economy immediately

Net Exports (NX)

• Exports minus imports ($NX = X - M$)—positive when a country sells more abroad than it buys, negative when imports exceed exports
• Exchange rate dependent—currency depreciation makes domestic goods cheaper abroad, boosting exports and reducing imports through the exchange rate effect
• Links domestic economy to global conditions—foreign income growth increases demand for exports; domestic income growth increases demand for imports

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Why the AD Curve Slopes Downward

The downward slope of AD isn't about individual goods getting cheaper—it reflects three macroeconomic effects that explain how the price level influences total spending.

The Wealth Effect (Real Balances Effect)

• Rising prices reduce purchasing power—when the price level increases, the real value of money holdings ($M/P$) falls, making households feel poorer
• Reduced wealth means reduced consumption—households cut back spending when their savings buy less, decreasing the C component of AD
• Works in reverse during deflation—falling prices increase real wealth, encouraging more consumption

The Interest Rate Effect

• Higher prices increase money demand—when prices rise, households and firms need more money for transactions, driving up the demand for money
• Increased money demand raises interest rates—with a fixed money supply, competition for money pushes up the real interest rate
• Higher rates reduce investment spending—the I component falls as borrowing becomes more expensive, reducing quantity demanded of real GDP

The Exchange Rate Effect

• Higher domestic prices affect currency value—when U.S. prices rise relative to foreign prices, U.S. goods become less competitive internationally
• Reduced competitiveness hurts net exports—foreigners buy fewer U.S. exports while Americans import more cheaper foreign goods
• NX component declines—the trade balance worsens, reducing aggregate demand at higher price levels

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What Shifts the AD Curve

Understanding shifters versus movements along the curve is critical. A change in the price level causes movement along AD; everything else shifts the entire curve.

Changes in Consumer Expectations and Wealth

• Consumer confidence shifts AD—when households expect better economic times, they spend more at every price level, shifting AD right
• Asset price changes matter—rising stock or home values increase household wealth, boosting consumption independent of income changes
• Tax policy affects disposable income—tax cuts increase after-tax income, raising consumption and shifting AD right (but indirectly, through the MPC)

Changes in Business Expectations and Interest Rates

• Animal spirits drive investment—Keynes's term for business optimism or pessimism; confident firms invest more regardless of current conditions
• Monetary policy works through investment—when the Fed lowers interest rates, borrowing becomes cheaper, increasing planned investment and shifting AD right
• Investment tax credits shift AD—policies that reduce the effective cost of capital goods encourage more business investment

Changes in Government Policy

• Fiscal expansion shifts AD right—increased government spending or tax cuts both increase aggregate demand, though through different mechanisms
• Fiscal contraction shifts AD left—spending cuts or tax increases reduce total spending in the economy
• Automatic stabilizers smooth fluctuations—unemployment insurance and progressive taxes automatically increase or decrease government's net impact on AD during business cycles

Changes in International Conditions

• Foreign income affects exports—when trading partners' economies grow, they buy more U.S. goods, increasing NX and shifting AD right
• Exchange rate changes shift AD—dollar depreciation makes U.S. goods cheaper abroad, boosting net exports
• Trade policy matters—tariffs reduce imports (increasing NX) but may trigger retaliation that reduces exports

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The Multiplier Effect

When any AD component changes, the total impact on real GDP exceeds the initial change due to the spending multiplier.

The Spending Multiplier

• Formula: $\frac{1}{1-MPC}$—if MPC is 0.8, the multiplier is 5, meaning a $100 increase in spending ultimately raises GDP by $500
• Works through successive rounds of spending—initial spending becomes income for others, who spend a fraction (MPC) of it, creating a chain reaction
• Applies to changes in C, I, G, or NX—any autonomous increase in spending triggers the multiplier process

The Tax Multiplier

• Formula: $\frac{-MPC}{1-MPC}$—smaller than the spending multiplier because tax changes work indirectly through consumption
• Negative sign indicates inverse relationship—tax cuts increase AD; tax increases decrease AD
• First-round leakage explains the difference—when government spends $100, all $100 enters the economy; when taxes fall by $100, only $MPC \times 100$ gets spent initially

Crowding Out

• Limits fiscal policy effectiveness—government borrowing to finance spending increases demand for loanable funds, raising interest rates
• Higher rates reduce private investment—the increase in G is partially offset by a decrease in I, weakening the multiplier effect
• More significant at full employment—crowding out is stronger when the economy is already near potential output

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Quick Reference Table

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Self-Check Questions

1. If the MPC is 0.8, calculate both the government spending multiplier and the tax multiplier. Why is the spending multiplier larger?

2. Which two AD components are most sensitive to changes in interest rates, and through what mechanisms do they respond?

3. Compare and contrast how expansionary fiscal policy and expansionary monetary policy shift the AD curve—which components does each policy primarily affect?

4. A country's major trading partner enters a recession. Explain which AD component is affected and in which direction the AD curve shifts.

5. An FRQ describes an economy in recession and asks you to recommend a fiscal policy response. Which would have a larger impact on real GDP: a $50 billion increase in government spending or a $50 billion tax cut? Justify your answer using the multiplier formulas.