The Components of Aggregate Demand
Idea
Aggregate demand is the sum of four components — — and the whole curve shifts when any determinant of a component changes at a given general price level. The curve is downward-sloping: a higher general price level reduces the real value of each component, so real national output demanded falls.
Mechanism
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Consumption (C) — demand by domestic households for domestically produced goods and services. It rises with consumer confidence (an optimistic outlook on jobs and pay brings spending forward), with wealth (appreciating assets make households feel richer), with the availability and cost of credit (cheaper loans finance big-ticket purchases), and with nominal income (more income from a growing economy raises induced consumption).
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Investment (I) — spending by firms on capital goods, both domestic business investment and foreign direct investment by multinationals. Firms invest while the expected return justifies the cost, captured by the marginal efficiency of investment (MEI), the expected rate of return on an investment. The MEI — and so investment — rises with a stronger economic outlook, lower corporate taxes, technological innovation that cuts the unit cost of capital, and lower interest rates that cut the cost of borrowing.
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Government expenditure (G) — all government consumption, investment and transfer payments. It is shaped by budget constraints (tax revenue and the cost of borrowing), by the number and severity of the microeconomic and macroeconomic problems the government is addressing, and by political factors around elections.
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Net exports (X − M) — the difference between export revenue and import expenditure. Both sides respond to foreign and domestic income levels, tastes and preferences, technology, trade policies such as tariffs, and the exchange rate — a depreciation of the domestic currency makes exports cheaper to foreigners and imports dearer at home, raising net exports.
Considerations
The same logic that governs a movement along the curve (a change in the general price level) is distinct from a shift of the curve (a change in any determinant above). Reading which is in play is the first step in an AD–AS analysis: a tax cut, an interest-rate change or an export shock shifts AD, whereas a change in the price level moves the economy along it.