The components of aggregate demand, why the AD curve slopes downwards, the determinants of consumption, investment, government spending and net trade, and the multiplier.

What this dot point is asking

AQA wants you to define aggregate demand and its components, explain why the AD curve slopes downwards, analyse the determinants of each component, and explain the multiplier. AD is half of the AD-AS model that runs through the entire macro paper.

The components of aggregate demand

In most economies consumption (C) is by far the largest component, typically around 60 percent of UK GDP, so changes in consumer spending dominate the cycle. Investment (I), spending by firms on capital goods and by households on new housing, is smaller but far more volatile, which is why it drives much of the cycle. Government spending (G) excludes transfer payments such as benefits, since these are not spending on output. Net exports can be positive or negative depending on the trade balance.

Why the AD curve slopes downwards

A change in the price level causes a movement along the AD curve. A change in any component for a reason other than the price level (a confidence shock, a tax cut, a change in the exchange rate) shifts the whole AD curve.

Determinants of the components

• Consumption depends on disposable income, interest rates, wealth (house and share prices), consumer confidence, and the availability of credit. The marginal propensity to consume (the fraction of extra income spent) is central to the multiplier.
• Investment depends on interest rates, business confidence (Keynes's "animal spirits"), expected demand and profits, the cost and price of capital goods, and corporation tax.
• Government spending depends on the fiscal stance (expansionary or contractionary) and the position in the economic cycle, partly via automatic stabilisers.
• Net exports depend on the exchange rate, relative inflation and competitiveness, and incomes at home and abroad (higher UK incomes raise imports).

The multiplier

The formula is $\text{multiplier} = \frac{1}{1 - MPC}$ or equivalently $\frac{1}{MPW}$, where $MPW = MPS + MPT + MPM$. With a marginal propensity to consume of 0.8, the multiplier is $\frac{1}{1 - 0.8} = 5$, so a 10 billion pound rise in investment could raise national income by 50 billion pounds. The multiplier works in both directions: a fall in injections causes a magnified fall in national income, which is why recessions can deepen quickly.