AP® Macroeconomics · Unit 3 · Topic 3.1
What Aggregate Demand Is
Aggregate demand is the total quantity of all goods and services bought in an economy at each possible price level, equal to consumption plus investment plus government spending plus net exports.
Every household, business, government, and foreign buyer purchasing goods and services made within a country gets added into one number at each price level. Economists compress all of that spending into a single curve, aggregate demand, or AD, plotted against the overall price level rather than the price of one good. AD is built from four spending streams: consumption (C) by households, investment (I) by businesses, government spending (G), and net exports (NX), exports minus imports. Add them up and you get GDP from the spending side: AD = C + I + G + NX.
AD slopes downward, but not for the reason a single market's demand curve does. In one market, a price rise pushes buyers toward substitute goods. There is no substitute economy to run to, so that logic cannot explain AD. Instead three effects do the work. A higher price level shrinks the real value of money people hold, so they feel poorer and spend less (the wealth effect). It also pushes up interest rates as people and firms borrow more to cover costs, which discourages investment and big purchases (the interest rate effect). And it makes domestic goods pricier relative to foreign goods, cutting exports and raising imports (the exchange rate effect). All three shrink total output demanded as price level rises.
This sets up the rest of the unit. AD interacts with short-run and long-run aggregate supply to pin down equilibrium output and price level, and shifts in C, I, G, or NX move the whole AD curve, which is exactly the lever fiscal policy pulls to close recessionary or inflationary gaps.
Key terms
- Aggregate demand (AD)
- The total quantity of a country's goods and services demanded at each possible price level.
- Wealth effect
- A higher price level reduces the real value of savings, so people spend less.
- Interest rate effect
- A higher price level raises interest rates, discouraging investment and interest-sensitive spending.
- Exchange rate effect
- A higher domestic price level makes exports relatively expensive and imports relatively cheap, lowering net exports.
- Net exports (NX)
- Exports minus imports, the trade component of aggregate demand.
Watch it explained
- How it worksHow do consumption, investment, government spending, and net exports stack into aggregate demand?
- Common mistakeWhy isn't the aggregate demand curve just a giant version of one market's demand curve?
- Going furtherWhat happens to aggregate demand when the price level is the only thing that changes?
- Ties togetherHow do the axes on an aggregate demand graph differ from those on a single market graph?
Check yourself
End of topic.