The components and determinants of aggregate demand, and short-run and long-run aggregate supply and their shifts.

What this dot point is asking

WJEC wants you to define and explain aggregate demand and its components, to explain the determinants and shifts of AD, and to distinguish short-run from long-run aggregate supply and explain what shifts each.

The answer

Aggregate demand and its components

The AD curve slopes downward, principally because a lower price level raises the real value of money and wealth (the real-balance and wealth effects), lowers interest rates, and makes domestic goods more competitive abroad. Consumption is the largest component in the UK and depends on real income, confidence, interest rates and wealth. Investment depends on interest rates, expected profits and confidence (the "animal spirits"). Government spending is set by fiscal policy. Net exports depend on the exchange rate, relative prices and incomes at home and abroad. A change in any of these shifts the whole AD curve.

What shifts aggregate demand

Because AD is a sum of four components, anything that raises one of them shifts AD right. A cut in interest rates raises consumption and investment; a rise in consumer or business confidence raises consumption and investment; a fiscal expansion raises government spending or, through tax cuts, consumption; a depreciation of the currency raises net exports. These are the levers that demand-side macroeconomic policy works through.

Short-run and long-run aggregate supply

SRAS slopes up because, with money wages sticky in the short run, a higher price level raises firms' profit margins and encourages more output. SRAS shifts with costs of production: a rise in wages, raw-material or energy prices, taxes on firms, or a depreciation that raises import costs shifts SRAS left; falling costs shift it right. LRAS represents the quantity and quality of resources: it shifts right with more or better capital (investment), a larger or more skilled workforce (education, training, net migration), and improved technology and efficiency, all of which raise potential output. The shape of LRAS (vertical in the Neo-Classical view, with a Keynesian horizontal range at low output) is the subject of the next topic.

Examples in context

Example 1. Consumer confidence and UK consumption. Because consumption is the largest component of UK aggregate demand, swings in consumer confidence have a powerful effect. When confidence collapses, as in a recession or a cost-of-living squeeze, households cut spending and raise precautionary saving, shifting AD left and deepening the slowdown; recovering confidence shifts AD right. This is why surveys of consumer confidence are watched as a leading indicator of demand.

Example 2. Energy prices as a supply-side shock. A sharp rise in global energy prices, as in 2022, raises firms' production costs across the economy, shifting SRAS to the left. The result is cost-push inflation combined with weaker output, a difficult combination because demand-side policy that fights the inflation worsens the output loss. It illustrates how a cost shock works through aggregate supply rather than aggregate demand, and why supply shocks are hard to manage.

Try this

Q1. State the four components of aggregate demand. [2 marks]

• Cue. Consumption (C), investment (I), government spending (G) and net exports (X minus M).

Q2. Explain one factor that would shift the short-run aggregate supply curve to the left. [3 marks]

• Cue. A rise in production costs, for example higher wages, raw-material or energy prices, higher taxes on firms, or a depreciation raising import costs, reduces output supplied at each price level and shifts SRAS left.