Aggregate Demand: Determinants, Curve Behavior, and the Multiplier Effect

Aggregate Demand

Definition and Components

Aggregate demand (AD) represents the total quantity of goods and services demanded in an economy at different price levels, typically measured using the GDP deflator or implicit price deflator. It is the sum of demand from four major sources:

• Personal Consumption – Household spending on goods and services

• Business Consumption – Investment in capital goods by firms

• Government Consumption – Expenditures by local, state, and federal governments

• Foreign Consumption – Net exports, calculated as exports minus imports

Formula:

$AD = C + I + G + (X - M)$ Where: C = Consumption I = Investment G = Government Spending X = Exports M = Imports

Aggregate Demand Curve

The aggregate demand curve is a graphical representation showing the relationship between the total quantity of output demanded (real GDP) and the price level. It typically slopes downward from left to right.

• X-axis: Real GDP (billions of base-year dollars per year)

• Y-axis: Price Level (GDP deflator)

Table: Example Points on the Aggregate Demand Curve

Point	Price Level	Aggregate Demand (Real GDP)
A	1.180	12,600
B	1.160	12,300
C	1.140	12,000
D	1.120	11,700
E	1.100	11,400

Reasons the Aggregate Demand Curve Slopes Downward

Key Effects

The downward slope of the AD curve is explained by three main effects:

• Wealth Effect: As the price level falls, the real value of money increases, making consumers feel wealthier and increasing consumption.

• Interest Rate Effect: Lower price levels reduce the demand for money, leading to lower interest rates and increased investment spending.

• International Trade Effect: A lower domestic price level makes domestic goods relatively cheaper for foreigners, increasing exports and reducing imports, thus raising net exports.

Movements Along the Aggregate Demand Curve

Price Level Changes

A movement along the AD curve occurs when the price level changes, affecting the quantity of real GDP demanded through the wealth, interest rate, and international trade effects.

• Example: If prices fall, purchasing power rises, allowing consumers to buy more with the same income, increasing aggregate demand.

• Example: If domestic prices rise, foreign buyers purchase fewer domestic goods, and domestic consumers buy more foreign goods, reducing aggregate demand.

Shifts in the Aggregate Demand Curve

Determinants of Shifts

A shift in the AD curve means that the aggregate quantity of goods and services demanded changes at every price level. This can be caused by changes in:

• Consumption (e.g., changes in consumer confidence, taxes, or wealth)

• Investment (e.g., changes in interest rates, business expectations)

• Government Purchases (e.g., fiscal policy changes)

• Net Exports (e.g., changes in foreign income, exchange rates)

Example: An increase in the child tax credit from $2,000 to $3,600 per child increases household disposable income, boosting consumption and shifting the AD curve to the right.

Example: A rise in oil prices due to geopolitical events increases import costs, reducing net exports and shifting the AD curve to the left.

The Multiplier Effect

Definition and Formula

The multiplier effect refers to the ratio of the change in real GDP demanded at each price level to the initial change in one or more components of aggregate demand.

Formula:

$\text{Multiplier} = \frac{\Delta \text{real GDP at each price level}}{\text{initial } \Delta \text{in the component of AD}}$

Multiplier Example #1

• Four people in the economy: Bob (lawn service), Lydia (assembly line worker), Frank (potato farmer), Davis (hardware store employee)

• Lydia's income increases by $1,000

• She spends $800 on landscaping (Bob), Bob spends $600 on potatoes (Frank), Frank spends $500 at the hardware store (Davis)

• Total GDP growth: $2,900

Multiplier Example #2

Change in Component of AD (billions)	Change in Real GDP at each Price Level (billions)	Multiplier
100	200	2
200	600	3
250	1000	4

Additional info: The table was partially incomplete; logical values for the missing multiplier and GDP change were inferred for completeness.

Investment and Aggregate Demand

Interest Rates and Real GDP

Investment is a key component of aggregate demand and is sensitive to changes in interest rates. Lower interest rates reduce the cost of borrowing, encouraging more investment and increasing aggregate demand.

• Graphical Analysis: A decrease in interest rates shifts the investment demand curve to the right, increasing the quantity of loanable funds and raising real GDP.

• Aggregate Demand Curve: An increase in investment shifts the AD curve to the right, resulting in higher equilibrium real GDP at each price level.

Formula for Investment Impact:

$\text{AD}_1 \rightarrow \text{AD}_2$ (shift to the right as investment increases)

Summary Table: Determinants and Effects on Aggregate Demand

Determinant	Effect on AD	Example
Consumption	Increase shifts AD right; decrease shifts AD left	Tax cuts increase disposable income
Investment	Increase shifts AD right; decrease shifts AD left	Lower interest rates boost business investment
Government Purchases	Increase shifts AD right; decrease shifts AD left	Stimulus spending during recession
Net Exports	Increase shifts AD right; decrease shifts AD left	Foreign income rises, increasing exports