This document provides an overview of aggregate demand, including its basic concept and components. Aggregate demand is the total demand for goods and services in an economy at a given overall price level. It has four main components: consumption (C), investment (I), government spending (G), and net exports (X-M). Each of these components is affected by various economic factors, such as consumer confidence, interest rates, fiscal policy, and global economic conditions. The document also discusses how the aggregate demand curve can shift based on changes in its underlying determinants like GDP, savings, and interest rates.

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A Research Work prepared for the
Subject Soc Sci 104 – Basic Economics with Taxation and Agrarian Reform
of Pangasinan State University – Lingayen Campus, Lingayen Pangasinan
Submitted By:
JERRICA P. VARGAS
____________________________
Submitted to:
MR. JAMESON N. ESTRADA
_____________________________
Date

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May 08, 2014
TABLE OF CONTENTS
I. Introduction ………………………………………………………………………………………………………...1
II. Aggregate Demand…………………………………………………………………………………...…………..1
Basic Concept of Aggregate Demand………………………………………………………..……………………2
Determinants of Aggregate Demand………………………………………………………………….…………..3
Components of Aggregate Demand ............................................................................................................. 4
A. Consumption (C) .............................................................................................................................. 4
1. Factors that affect consumption……………………………………………………………………….5
a) Consumer Confidence…………………………………………………………………………....5
b) Interest Rates…………………………………………………………………………………........5
c) Consumer Debt…………………………………………………………………………………...5
d) Wealth……………………………………………………………………………………………...5
B. Investment (I)……………………………………………………………………………………………..5
1. Factors that affect investment……………………………………………………………………….6
a) Interest Rates……………………………………………………………………………………..7
b) Business Confidence…………………………………………………………………………...7
c) Investment Policy………………………………………………………………………………..7
d) National Income…………………………………………………………………………………7
C. Government Spending (G)…………………………………………………………………………….7
1. Factors that affect Government Spending……………………………...………………………….7

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a) Fiscal Policy…………………………………………………………………………………..7
b) Politics………………………………………………………………………………………..7
c) State and Local Taxes…………………………………………………………………...…8
D. Exports and Imports (X-M)…………………………………………………………………………..8
1. Factors that affect Exports and Imports……………………………………………………..……8
a) Global Prosperity…………………………………………………………………………….8
b) Exchange Rates………………………………………………………………………………8
c) Trade Barriers…………………………………………………………………………………9
Aggregate Demand Curves......................................................................................................................... 10
A. Aggregate Demand-Aggregate Supply Model ............................................................................... 11
B. Shifting the AD Curve..................................................................................................................... 12
III. Analysis / Applications ........................................................................................................................... 13
IV. Conclusions………………………………………………..……………………………………………………14
V. References. ............................................................................................................................................ 15

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I – INTRODUCTION
AGGREGATE DEMAND
Aggregate demand tells the quantity of goods and services demanded in an economy at a given
price level. In effect, the aggregate demand curve is a just like any other demand curve, but for the sum
total of all goods and services in an economy. It tells the total amount that all consumers, businesses, and
the government are willing to spend on goods and services at different price levels.
The aggregate demand curve can be thought of just like a demand curve for a firm. When the
price level is high, aggregate demand is low; when the price level is low, aggregate demand is high. The
aggregate demand curve lies in a plane consisting of the price level and income or output. It shows a
downward slope with price level on the vertical axis and income or output on the horizontal axis. As such,
the aggregate demand curve outlines the relationship between income or output and the price level. It is
important to notice that aggregate demand is a schedule because as the price level changes, the income
or output also changes.

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II – CONTENTS
Basic Concept of Aggregate Demand
1. There are four sources of demand that firms face: households (personal consumption), other firms
(investment), government agencies (government purchases), and foreigners (net exports).
2. Aggregate demand is the relationship between the total quantity of goods and services demanded
(from all of the four sources of demand) and the price level, all other determinants of spending
unchanged.
3. The aggregate demand curve is a graphical representation of aggregate demand.

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Determinants of Aggregate Demand
The determinants of the aggregate demand curve are shown below:
1) GDP-, GDP includes the components of Consumption, Investment, Government Spending, and Net
Exports. Whenever any one of these components is affected, the aggregate demand curve will shift.
When GDP increases, it will shift to the right, and when GDP decreases, the curve will shift to the left.
2) Savings- When consumer saving increases, they decide to spend less on consumption, which affects
GDP. When saving increases, the aggregate demand curve will shift to the left. Conversely, when
consumers save less and spend more, the aggregate demand curve will shift to the right.
3) Interest Rates- When interest rates are low, businesses will increase investment, which will shift the
aggregate demand curve to the right. When interest rates are high, investment will decrease because it
will be more expensive to take out loans to invest. Also, savings will increase since consumers will get a
higher return on savings with higher interest rates. These higher interest rates will cause the aggregate
demand curve to shift to the left.
4) Consumer Confidence- When consumer confidence is high, consumers have more faith in the
economy. They will not fear spending as much, and will not see a need to save a lot of extra money. This
will cause consumption to increase, shifting the aggregate demand curve to the right. A decrease in
consumer confidence will have the opposite effect, shifting the aggregate demand curve to the left.

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Components of Aggregate Demand
An aggregate demand curve is the sum of individual demand curves for different sectors of the
economy. The aggregate demand is usually described as a linear sum of four separable demand
sources:
AD = C + I + G (X-M)
Where:
 C is consumption (may also be known as consumer spending) = ,
where Y is consumers' income and T is taxes paid by consumers,
 I is Investment,
 G is Government spending,
 NX = X - M is Net export,
 X is total exports, and
 M is total imports = .
These four major parts, which can be stated in either 'nominal' or 'real' terms, are:
A. Consumption (C)
This is the expenditure by consumer on goods and services, including both durable and non-durable
goods but not including saving. While values vary widely between economies, 'C' usually accounts for 40-
60% of GDP. Because of this, high or low consumer confidence, and consequently high or low consumer
spending can change the course in an economy.
- personal consumption expenditures (C) or "consumption," demand by households and
unattached individuals; its determination is described by the consumption function. The
consumption function is C= a + (MPC)(Y-T)
- a is autonomous consumption, MPC is the marginal propensity to consume, (Y-T) is the
disposable income.
1. Factors that affect consumption:

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a) Consumer Confidence – if consumers are confident about future income, job stability,
and the economy is growing and stable, spending is likely to increase. However, job
insecurity and uncertainty over income is likely to delay spending. An increase shifts AD
to the right.
b) Interest Rates – lower interest rates tend to increase consumption because larger goods
are usually purchased on credit and if interest rates are low, then its cheaper to borrow.
Consumers mostly borrow to buy houses, which is one of the biggest purchases and
lower interest rates means lower mortgage payments, so households can spend more on
other goods. Some economists argue that lower interest rates also make saving less
attractive, but there is no real evidence. So, lower interest rates increase Aggregate
Demand.
c) Consumer Debt - If a consumer has a lot of debt, he is unlikely to buy more since he
would have to pay his debt off first. Low consumer debt increases consumption and
aggregate demand.
d) Wealth - Wealth are assets held by a household, such as property or stocks. An increase
in property is likely increase to consumption.
B. Investment (I)
Strictly known as Gross Domestic Fixed Capital Formation, this is the money spent by firms (not the
government or consumers) on capital investment ie. New machinery and factories. There is some
argument as to whether human capital (training) should be included. Investment also includes stocks and
goods and services not yet completed; for example, car firms will likely have many machines part-built or
stored at any one time. Since they cannot be included in consumption since they have not been
purchased, stores must be included in I.
Investment makes up approximately 10% of GDP in most economies, and governments are often
keen to increase this value, as investment helps to increase the possible output of economy (strictly
LRAS or the PPF).

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- Gross private domestic investment (I), such as spending by business firms
on factory construction. This includes all private sectors spending aimed at the production of
some future consumable.
 In Keynesian economics, not all of gross private domestic investment counts as part of
aggregate demand. Much or most of the investment in inventories can be due to a short-fall
in demand (unplanned inventory accumulation or "general over-production"). The Keynesian
model forecasts a decrease in national output and income when there is unplanned
investment. (Inventory accumulation would correspond to an excess supply of products; in
the National Income and Product Accounts, it is treated as a purchase by its producer.)
Thus, only the planned or intended or desired part of investment (Ip) is counted as part of
aggregate demand. (So, I do not include the 'investment' in running up or depleting inventory
levels.)
 Investment is affected by the output and the interest rate (i). Consequently, we can write it as
I(Y,i). Investment has positive relationship with the output and negative relationship with the
interest rate. For example, an increase in the interest rate will cause aggregate demand to
decline. Interest costs are part of the cost of borrowing and as they rise, both firms and
households will cut back on spending. This shifts the aggregate demand curve to the left.
This lowers equilibrium GDP below potential GDP. As production falls for many firms, they
begin to lay off workers, and unemployment rises. The declining demand also lowers the
price level. The economy is in recession.
1. Factors that affect investment:
a) Interest Rates - firms borrow from banks to purchase large capital, and if the interest
rate decreases, it makes it cheaper for firms to invest and provides incentive for firms
to take risk.
b) Business Confidence - if firms are confident about the economy and its future growth,
they are more likely to invest.

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c) Investment Policy – if governments provide incentive for firms to invest, then
investment can increase. Incentives such as tax breaks, subsidies, loans at lower
interest rates. However, corruption and bureaucracy deters investment.
d) National Income - as firms increase output, they would need to invest in new
machines. This relationship is known as The Accelerator.
C. Government Spending (G)
Strictly known as General Government Final Consumption, it is the expenditure by the government,
not including transfer payments (e.g. social security, welfare benefits since they are simply moving money
around the economy). Governments usually spend on public and merit goods. These are microeconomic
terms - a public good is one that is provided to everybody and cannot be exclusive by its nature (think
street lighting), whilst a merit good is one that is under-supplied and under-demanded as consumers do
not appreciate all the benefits, because some of those benefits do not directly apply to the buyer (think
environmentally friendly vehicles).
Changes in government spending as a method of controlling the economy is known as fiscal policy - more
of that later on.
- Gross government investment and consumption expenditures (G).
1. Factors that affect Government Spending:
a) Fiscal Policy: At the federal level, the desire to counter instability caused by other
expenditures though fiscal policy is always a possibility. If aggregate demand decreases
because of less spending from the household or business sectors, then the government
sector is often inclined to spend more. Alternatively, if aggregate demand increases to
the point of triggering inflation, then the government is likely to spend less.
b) Politics: Political considerations are almost always bubbling near the surface of
government spending. Perhaps the political winds blow in the direction of reducing the
federal deficit. Such a force could decrease government purchases and aggregate
demand. Or perhaps a rather vocal and financially powerful interest group convinces
political leaders to spend more on worthy activities, like the space program, national

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defence, or environmental quality. This is bound to increase government purchases and
aggregate demand.
c) State and Local Taxes: At the state and local level, which accounts for about two-thirds of
total government purchases, a key determinant is tax collections. A boost in state and
local tax collections, which usually happens when the economy is strong, causes state
and local government purchases to increase. And when the economy is weak, tax
collections fall, and so too do state and local government purchases.
D. Exports and Imports (X-M)
Exports are a positive figure on Aggregate Demand as overseas customers purchase goods and
services produced here. Imports, on the other hand, are not produced here, though they are consumed
here. Think of imports as money leaving the economy.
- Net exports (NX and sometimes (X-M)), i.e., net demand by the rest of the world for the country's
output.
In sum, for a single country at a given time, aggregate demand (D or AD) = C + Ip + G + (X-M).
These macroeconomic variables are constructed from varying types of microeconomic variables from
the price of each, so these variables are denominated in (real or nominal)currency terms.
1. Factors that affect Exports and Imports:
a) Global Prosperity: The health of foreign economies is one determinant. When other
nations are in fine economic shape, their consumers tend to buy more goods, including
more goods produced in the other countries. That means the domestic economy exports
more to them and aggregate demand increases.
b) Exchange Rates: Currency exchange rates are another determinant of net exports. An
exchange rate is the price of one nation's currency in terms of another. When this rate
changes, it affects the relative prices of exports and imports. When those relative prices
change so too do exports and imports and thus net exports and aggregate demand.

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c) Trade Barriers: The assortment of trade barriers, tariffs, restrictions, and subsidies that
nations tend to use to gain a competitive advantage in the game of foreign trade are also
a key determinant. Greater restrictions on imports tend to increase net exports and thus
aggregate demand--at least in the short run. In the longer run, other nations tend to
retaliate by imposing their own restrictions on the export side and that can reduced
aggregate demand.

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Aggregate Demand Curves
Understanding of the aggregate demand curve depends on whether it is examined based on changes
in demand as income changes, or as price change.
Real money balances effect
As the price level falls, the real value of money balances held increases. This increases the real
purchasing power of consumers.
Prices and interest rates
A lower price level increases the real interest rate - there will be pressure on the monetary
authorities to cut nominal interest rates as the price level falls. Lower nominal interest rates should
encourage an increase in consumer demand and planned investment.
International competitiveness
If the UK price level is lower than other countries (for a given exchange rate), UK goods and
services will become more competitive. A rise in exports adds to aggregate demand and therefore
boosts national output.

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A. Aggregate Demand-Aggregate Supply Model
Sometimes, especially in textbooks, "aggregate demand" refers to an entire demand curve
that looks like that in a typical Marshallian supply and demand diagram.
Thus, that we could refer to an "aggregate quantity demanded" (Y
d
= C + Ip + G + NX in real or inflation-
corrected terms) at any given aggregate average price level (such as the GDP deflator), P.
In these diagrams, typically the Y
d
rises as the average price level (P) falls, as with the AD line in
the diagram. The main theoretical reason for this is that if the nominal money supply (M
s
) is constant, a
falling P implies that the real money supply (M
s
/P)rises, encouraging lower interest rates and higher
spending. This is often called the "Keynes effect."
Carefully using ideas from the theory of supply and demand, aggregate supply can help
determine the extent to which increases in aggregate demand lead to increases in real output or instead
to increases in prices (inflation). In the diagram, an increase in any of the components of AD (at any
given P) shifts the AD curve to the right. This increases both the level of real production (Y) and the
average price level (P).
But different levels of economic activity imply different mixtures of output and price increases. As
shown, with very low levels of real gross domestic product and thus large amounts of unemployed
resources, most economists of the Keynesian school suggest that most of the change would be in the
form of output and employment increases. As the economy gets close to potential output (Y*), we would
see more and more price increases rather than output increases as AD increases.
Beyond Y*, this gets more intense, so that price increases dominate. Worse, output levels greater
than Y* cannot be sustained for long. The AS is a short-term relationship here. If the economy persists in
operating above potential, the AS curve will shift to the left, making the increases in real output transitory.
At low levels of Y, the world is more complicated. First, most modern industrial economies
experience few if any falls in prices. So the AS curve is unlikely to shift down or to the right. Second,
when they do suffer price cuts (as in Japan), it can lead to disastrous deflation.

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B. Shifting the AD Curve
A change in one of the components of aggregate demand will cause a shift in the aggregate demand
curve. For example there might be an increase in export demand causing an injection of foreign
demand into the domestic economy. The government may also increase its own expenditure and
businesses may raise the level of planned capital investment spending.

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III – ANALYSIS / PROBLEMS
Sticky Prices and Wages
Supports Learning Objective: Identify the determinants of aggregate supply and distinguish between a
movement along the short-run aggregate supply curve and a shift of the curve.
The aggregate supply curve plots the relationship between the price level and quantity of real
GDP supplied by firms. Because price level changes do not affect the factors that cause potential real
GDP to change (for example, increases in the labor force or the capital stock), the long-run aggregate
supply curve is drawn as a vertical line. Changes in real GDP do occur in response to price level changes
over short periods of time when input prices rise more slowly than output prices. This is why the short-run
aggregate supply curve is upward sloping. Economists use the phrases ―sticky wages‖ and ―sticky prices‖
to refer to the slow response of wages and other input prices, as well as some output prices, to price level
changes. To help understand why prices and wages may be sticky, let’s use the example of ―Bill’s Glue
Emporium,‖ a firm that sells glue and other adhesives to businesses. Assume the price level increases by
10 percent in 2012. Bill does not plan to buy new equipment or tools during the year, and the wages of
Bill’s workers are not adjusted until the end of the year. Explain why Bill would choose each of the
following alternative responses to the price level change.
a. Bill increases the price and output of glue during 2012 but reduces the output of glue to its former level
in 2013. Answer: The price level increase means that other output prices have risen. Bill believes that he
will sell more glue, even at a higher price. If this price increase sticks (pun intended), then his profits will
increase in 2012 because his capital and labor costs will not rise. But his workers will probably demand a
wage increase in 2013 to compensate for the reduction in real income caused by the price level increase.
Sellers of capital goods will also want to raise their prices. If Bill’s input prices rise by the same amount as
prices have risen, he will decide in 2013 to reduce his output of glue to its former level.
b. Bill does not raise the price of glue but does increase the output of glue in 2012. In 2013, he raises
glue prices and reduces the production of glue to its former level. Answer: Bill might choose this option if
he is not sure if the increase in the price level will be sustained. If he raises prices in 2012, he risks losing

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customers to other glue sellers. In addition, if he raises his prices only to lower them later in the year, he
will have incurred menu costs twice – costs that he can avoid by not raising his prices in the first place.
Because his labor and capital costs will not rise in 2012, he can earn a profit from selling a higher output
of glue even without raising his prices. In 2013, his workers and capital goods suppliers will likely demand
higher wages and prices to compensate for the reduction in real income caused by the price level
increase. Bill will raise his prices and reduce his output of glue to its former level.

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IV – CONCLUSIONS
I saw that the aggregate demand curve slopes downward, reflecting the tendency for the
aggregate quantity of goods and services demanded to rise as the price level falls and to fall as the price
level rises. The negative relationship between the price level and the quantity of goods and services
demanded results from the wealth effect for consumption, the interest rate effect for investment, and the
international trade effect for net exports. We examined the factors that can shift the aggregate demand
curve as well. Generally, the aggregate demand curve shifts by a multiple of the initial amount by which
the component causing it to shift changes.
I distinguished between two types of equilibria in macroeconomics—one corresponding to the
short run, a period of analysis in which nominal wages and some prices are sticky, and the other
corresponding to the long run, a period in which full wage and price flexibility, and hence market
adjustment, have been achieved. Long-run equilibrium occurs at the intersection of the aggregate
demand curve with the long-run aggregate supply curve. The long-run aggregate supply curve is a
vertical line at the economy’s potential level of output. Short-run equilibrium occurs at the intersection of
the aggregate demand curve with the short-run aggregate supply curve. The short-run aggregate supply
curve relates the quantity of total output produced to the price level in the short run. It is upward sloping
because of wage and price stickiness. In short-run equilibrium, output can be below or above potential.
If an economy is initially operating at its potential output, then a change in aggregate demand or
short-run aggregate supply will induce a recessionary or inflationary gap. Such a gap will be closed in the
long run by changes in the nominal wage, which will shift the short-run aggregate supply curve to the left
(to close an inflationary gap) or to the right (to close a recessionary gap). Policy makers might respond to
a recessionary or inflationary gap with a nonintervention policy, or they could use stabilization policy.

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V - REFERENCES
I. Reference Books
AByatt, Sir Ian. (April 2007). Regulating Public Utilities – Outputs, Owners and Incentives. Occasional Lecture
20, Centre for the Study of Regulated Industries.
Azarcon, E. R. S., et al. (2005). Entrepreneurship Principles and Practices
(A modular approach). Baguio City: Valencia Educational Supply.
Ballada, S. & Ballada, S. (2007). Income Taxation. Manila:
Domdane Publishers.
II. Electronic References:
Baumol, W. J., & A.S. Blinder. Economics. New York: Harcourt Brace & Company, 1994.
Elmer G. Wiens: Classical & Keynesian AD-AS Model Retrieved from
http://en.wikipedia.org/wiki/Aggregate_demand#History
Mankiw, N. G. Principles of Economics. New York: Harcourt Brace College Publishers, 1998.
Mankiw, N. G. Macroeconomics. New York: Worth Publishers, 1997
coursework.mnsfld.edu/.../Chapter%207%20Aggregate%20Demand%20... Retrieved from
http://www.macrobasics.com/chapters/chapter12/lesson122/
http://www.tutor2u.net/economics/content/topics/ad_as/ad-as_notes.htm
AGGREGATE DEMAND DETERMINANTS, AmosWEB Encyclonomic WEB*pedia, Retrieved from
http://www.AmosWEB.com, AmosWEB LLC, 2000-2014. [Accessed: May 16, 2014].
CHANGE IN AGGREGATE DEMAND, AmosWEB Encyclonomic WEB*pedia, Retrieved from
http://www.AmosWEB.com, AmosWEB LLC, 2000-2014. [Accessed: May 16, 2014].
Jathon Sapsford and Norihiko Shirouzu, ―Mom, Apple Pie and...Toyota?‖ Wall Street Journal, May 11,
2006, p. B1.
III. Other Sources