The components of AD, C + I + G + (X − M), why the AD curve slopes down and what shifts it. Through the collapse in spending in 2020.
When lockdowns began in March 2020, households stopped spending in shops, restaurants and on travel, firms put off investment and exports fell. UK real GDP fell by around 10% in 2020, the largest annual fall on record. Furlough and business support held up incomes and spending.
What makes up total spending in an economy, and what makes it rise or fall?
Source: Office for National Statistics, GDP annual estimates.
Aggregate demand (AD) is the total planned spending on an economy’s goods and services at each price level, over a period of time.
AD = C + I + G + (X − M)
The AD curve plots the price level against real GDP (output adjusted for inflation), holding other influences constant (ceteris paribus).
Consumers suddenly become worried about losing their jobs.
They cut back on spending and save more, at every price level.
What happens to aggregate demand?
Consumption is the biggest part of aggregate demand. If households spend less at every price level, AD shifts to the left. A fall in confidence like this is one of the main causes of recessions.
At price level P1, total planned spending is Y1.
If the price level falls to P2, real GDP demanded rises to Y2: a movement along AD. Three reasons. Money buys more, so people feel wealthier and spend more. Interest rates tend to fall, encouraging borrowing to spend. And UK goods become cheaper than foreign goods, so exports rise and imports fall.
Check: Why does AD slope downwards?
Three effects: real wealth (money buys more), interest rates (a lower price level means less money is needed for transactions, so interest rates fall) and trade (UK goods become cheaper than foreign goods).
Anything other than the price level that changes C, I, G or X − M shifts the whole curve. A rise shifts AD right, to AD2: more real GDP demanded at every price level.
A fall in any component shifts AD left, to AD3. Causes include: higher interest rates, lower consumer or business confidence, cuts in government spending or higher taxes, a stronger pound making exports dearer and recessions in trading partners.
Check: Which would shift AD to the left?
Higher rates make borrowing dearer and saving more attractive, cutting C and I.
Back to 2020: consumption, investment and exports all fell, so AD shifted sharply left. Furlough, a transfer rather than government spending on output, held up incomes and so consumption, stopping AD falling even further.
A change in the price level moves along the AD curve; it does not shift it. AD only shifts when something else changes C, I, G or X − M.
Explain two factors that could cause aggregate demand to increase.
Aggregate demand is the total planned spending on an economy’s goods and services at each price level: AD = C + I + G + (X − M).
One factor is a fall in interest rates. Borrowing becomes cheaper and saving less rewarding, so households spend more, for example on goods bought on credit, and firms invest more because borrowing to buy machinery costs less. Consumption and investment rise at every price level, shifting AD to the right.
A second factor is a rise in government spending, for example on the NHS or infrastructure. G is a component of AD, so higher spending raises AD directly at every price level, again shifting AD to the right.
However, the size of the shift depends on confidence: if households are worried about the future, they may save more rather than borrow after a rate cut. A rise in government spending financed by higher taxes adds less to AD than one financed by borrowing.
[Diagram: AD1 and AD2 to the right of AD1, with the axes labelled price level and real GDP.]
UK output in 2020: Office for National Statistics. Diagrams drawn with Rough.js and perfect-freehand, both MIT licensed. Your answers are saved only on this device.