Aggregate demand is the total amount of planned expenditure at each price level, as a formula AD = C + I + G + (X – M).

Imports are subtracted because they are not part of UK output.

In the same way we draw demand curves in microeconomics, we can draw aggregate demand curves in macroeconomics. However, it is very important to note that the axes are labeled slightly differently. On the y-axis instead of price we write prices or price level (I prefer writing price level as it makes the difference more obvious to the reader). On the x-axis we write output. The x-axis is showing the quantity demanded of the total output of goods and services. Because, as we saw earlier with the circular flow of income, output and income are the same the x-axis could also be labeled real national income.

The AD curve represents a series of points. Each point on the curve indicates the planned expenditure on goods and services at the corresponding price level. It is important to understand that what people plan to do and what is eventually achieved is not the same thing. You will also see in textbooks and exam papers other variants on the x-axis. You may see it labeled real national income. However the x-axis is labeled remember it is always showing essentially the same thing – the output of goods and services. Notice too that aggregate demand curves slope downwards from left to right, that is to say they have negative gradients. The reasons why they slope downwards is similar to why demand curves in microeconomics slope downward, but there are subtle differences:

1. The wealth effect (the real balance effect) When we looked at demand curves in microeconomics we saw that at higher prices people cannot afford to buy as much and at lower prices they could afford more. This is a simple mathematical deductive proof. With macroeconomics and the aggregate demand curve the income effect works in a similar but slightly different way. When prices are rising, P1 to P2, i.e. there is inflation and we would expect wages would also be going up to. However, prices usually go up first and wages lag behind, so the quantity demanded for all goods and services falls, Q1 to Q2. The real- balance effect says that a change in aggregate expenditures on real production made by the household, firms, government, and foreign sectors results because a change in the price level affects the purchasing power of money.

2. The trade effect (net exports or substitution effect) With the microeconomic demand curve if the price of a can of Coke increased some people will buy Pepsi instead. With the macroeconomic aggregate demand curve when prices go up it is the price of all domestic goods and services and if the prices of every other countries’ goods and services remain the same (the ceteris paribus condition) then people will buy the cheaper imported goods rather than the now more expensive domestically produced goods.

3. Interest rate effect As the price level rises, households and firms need more money to handle the same quantity of demand, but the money supply is fixed. The increased quantity demanded for a fixed supply of money causes the interest rate to rise too. As interest rate rises, spending which is responsive to rate of interest falls, for example spending on cars which are usually bought with bank loans is likely to be less.

The components of aggregate demand adjusted for inflation (base year 2009)

In the next chart we see the components of aggregate demand in 2011 in bar graph format at current prices, i.e not adjusted for inflation. Note that gross domestic product is over 1.5 trillion pounds.

The Components of Aggregate Demand:

C: Consumers' expenditure on goods and services
Also known as consumption, this includes demand for consumer durables (e.g. audio-visual equipment and vehicles) & non-durable goods and services such as food and tickets for football matches, which are “consumed” and must be re-purchased.

Consumer spending is the most important part of aggregate demand, making up around 65% of the total in the UK.

I: Investment
Investment is sometimes called capital consumption, because it is spending on capital goods. Capital is defined as man-made goods used to produce other goods, examples include factory buildings, lorries, machines and computers.

Capital investment spending in the UK accounts for between 15-20% of GDP. Investment is an important component of AD, but always remember that it affects the ‘supply-side’ of the economy too.

Bear in mind that when households put money into the stock market or into an interest bearing account at a bank - this is not investment, this is saving which is defined as income that is not spent.

G: Government Spending
This is central and local government spending on final goods and services. It includes non-marketed services such as health and education. Care needs to be taken to avoid ‘double-counting’, so one of the biggest items of government spending (pensions and benefits) is excluded because these are merely transfer payments to some households, who then go on to spend the money, and this gets recorded as consumption not Government spending.

(X-M) Net exports
X: Exports of goods and services - Exports sold overseas is spending that adds to aggregate demand.

M: Imports of goods and services - Imports involves money leaving the country and so aggregate demand falls.

Net exports measure the value of exports minus the value of imports. When net exports are positive, there is a trade surplus (adding to AD); when net exports are negative, there is a trade deficit (reducing AD). For most of the last 40 years the UK has had a deficit on the balance of trade.

It is useful to know the approximate proportions of each of the components of AD in order to evaluate how important each is when they change. It is also worth bearing in mind that the proportions of each component are different from country to country. For example, China has a higher proportion of GDP that comes from investment compared to the UK - which of course has long-term consequences.