6.4 - Aggregate Demand Curve
The aggregate demand curve and movements along it
The aggregate demand (AD) curve shows the total demand for goods and services in an economy at different price levels. It shares similarities with a standard demand curve but uses national output on the x-axis and the average price level (often measured by indices like the Consumer Price Index in the UK) on the y-axis.
Similarities to a normal demand curve
- The AD curve slopes downwards, meaning that as the price level falls, the quantity of output demanded rises because lower prices allow consumers to purchase more with their money.
- A change in the price level causes a movement along the AD curve, rather than a shift of the curve itself.
- For example, if the price level increases from P to P1, output demanded decreases from Y to Y1.
Reasons for reduced output when the price level rises
A higher price level leads to lower aggregate demand and reduced national output for several reasons:
- Lower domestic consumption - Goods and services become more expensive, reducing the amount people can buy.
- Decreased demand for exports - Domestically produced items become less competitive on international markets.
- Increased demand for imports - If foreign prices remain stable, imports appear cheaper relative to domestic goods, diverting spending abroad.
Causes and effects of shifts in the aggregate demand curve
Shifts in the AD curve occur when factors other than the price level change the overall level of demand in the economy. These shifts affect consumption, investment, government spending, or net exports (exports minus imports).
Factors causing a rightward shift in the AD curve
A rightward shift indicates an increase in aggregate demand, allowing more output at any given price level.
This can result from:
- Rise in consumption - For instance, a cut in income tax boosts disposable income, encouraging more spending.
- Increase in government spending - If a government adopts an expansionary fiscal policy by raising expenditure without matching tax increases, it injects money into the economy.
- Growth in net exports - A weaker domestic currency makes exports cheaper and imports more expensive, boosting net exports.
The shift means that at a fixed price level P, output rises from Y to Y1. Alternatively, at a fixed output Y, the price level increases from P to P1. Such a shift also increases employment, as higher output creates derived demand for labour to produce additional goods and services.
Factors causing a leftward shift in the AD curve
A leftward shift signals a decrease in aggregate demand, leading to less output at any price level.
Common causes include:
- Fall in consumption and investment - A rise in interest rates encourages saving over spending and makes borrowing for investment more costly.
- Decline in net exports - A stronger domestic currency raises export prices and lowers import costs, reducing net exports.
This shift results in lower output (from Y to Y2) at a constant price level P, or a reduced price level (from P to P2) at a constant output Y. Employment levels typically fall as reduced output decreases the need for workers.
The multiplier effect and its impact on aggregate demand
The multiplier effect amplifies the impact of an initial change in spending on overall aggregate demand. It occurs because one person's spending becomes another's income, creating successive rounds of expenditure in the circular flow of income.
How the multiplier effect works
When there is an injection into the economy (such as increased government spending on infrastructure), it causes an initial rise in AD, shifting the curve rightward.
However, the money circulates multiple times:
- For example, government funds used for wages lead to increased consumer spending, generating further income and demand.
- This process continues until the money leaks out through savings, taxes, or imports.
The overall shift in the AD curve is larger than the initial injection—the greater the multiplier, the bigger the shift.
Formula for the multiplier using marginal propensity to consume
The size of the multiplier depends on the marginal propensity to consume (MPC), which is the proportion of additional income that households spend rather than save.
Where:
- MPC = Marginal propensity to consume (e.g., if MPC is 0.75, households spend 75% of extra income)
Challenges in measuring the multiplier
- The multiplier's size varies with leakages from the circular flow (e.g., higher savings or imports reduce it).
- It is hard to measure accurately due to time lags—effects of spending (like on transport improvements) may take years to fully emerge.
- Constant economic changes make precise control of AD difficult for governments.
Worked example - Calculating the multiplier using MPC
Suppose an economy has an MPC of 0.6, and the government injects £75 million through increased spending. Calculate the multiplier and the total increase in national income.
Step 1: Identify the values
- MPC = 0.6
- Injection = £75 million
Step 2: Apply the multiplier formula
Step 3: Calculate total increase in national income
Total increase = injection × multiplier
Total increase = £75 million × 2.5 = £187.5 million
Short-run economic growth caused by increases in aggregate demand
Short-run economic growth occurs when a rise in aggregate demand boosts national output without changing the economy's long-term productive capacity. This is shown by a rightward shift in the AD curve, interacting with the short-run aggregate supply (SRAS) curve.
Demand-side factors causing short-run growth
Growth is driven by increases in AD components:
- Lower interest rates - These encourage investment by businesses and consumption by households.
- Higher government spending - For example, increasing welfare benefits raises both government expenditure and consumer spending.
In a diagram, this shifts AD to AD1, raising output from Y to Y1 and the price level from P to P1 along a fixed SRAS curve.
Influences on the extent of the AD shift
The magnitude of the shift depends on:
- Marginal propensity to consume (MPC) - A higher MPC means more of any additional income is spent, amplifying growth.
- Size of the multiplier effect - Larger multipliers lead to greater shifts, as initial spending generates more rounds of economic activity.