Macroeconomics guide, Unit 3, step 5 of 23Previous step Next step

Step 5: Aggregate Demand

By the EconTutorials team. 10-minute read with 6 practice questions.

SyllabusAP Macro 3.1 · Cambridge 4.3 · IB 3.2

In 30 seconds

Aggregate demand (AD) is total planned spending on a country’s output at each price level: $ AD = C + I + G + (X – M) $.
AD slopes downward because of three macroeconomic effects: the wealth effect, the interest rate effect and the net exports effect. The micro substitution and income effects do not apply.
A change in the price level moves the economy along AD. A change in anything else that affects C, I, G or (X − M) shifts AD.
The multiplier means a change in spending changes GDP by more than itself: $ k = \dfrac{1}{1 – \text{MPC}} = \dfrac{1}{\text{MPS} + \text{MPT} + \text{MPM}} $.

Video lesson coming soonA short animated lesson for this step will appear here.

What aggregate demand means

Picture everyone in the country going shopping at once: families buying groceries and phones, firms buying new machines, the government paying for new schools and buses, and people abroad buying the country’s exports. Add it all up and you have aggregate demand.

Key termAggregate demand (AD): the total planned spending on domestically produced goods and services at each price level, holding everything else constant.

\[ AD = C + I + G + (X – M) \]

These are exactly the components of the expenditure approach to GDP in Step 1. That is no coincidence: AD is total planned spending, shown at different price levels. On the AD diagram:

the vertical axis is the price level, the average price of all goods and services, measured by an index such as the GDP deflator;
the horizontal axis is real GDP, the total quantity of output at constant prices.

Common mistakeLabelling the axes “P” and “Q”, or drawing a market demand curve and calling it AD. On a macro diagram, write “Price level” and “Real GDP”. Examiners check the axes first, and wrong labels lose marks straight away.

Why AD slopes downward

In microeconomics, the demand for one good slopes down because of the substitution effect (you switch to other goods) and the income effect. Neither works here. When the general price level falls, every domestic price falls together, so there is nothing to switch to. Instead, three macroeconomic effects do the job.

The wealth effect. You have £500 in the bank. If prices fall, that £500 buys more, so you feel richer and spend more. Consumption (C) rises. The effect is real but fairly small.
The interest rate effect. When prices are lower, people and firms need less money for everyday transactions. Demand for money falls, so (with the money supply fixed) interest rates fall. Cheaper borrowing raises investment (I) and spending on houses and cars. In most estimates this is the biggest of the three channels.
The net exports effect. A lower domestic price level makes home-made goods cheaper than foreign goods, so exports rise and imports fall. Lower interest rates also push money abroad, weakening the currency and boosting net exports further. (X − M) rises.

Exam tipFor each effect, trace the full chain: lower price level → what changes → which component of AD rises. For example: “a lower price level reduces money demand, which lowers interest rates, which raises investment, so AD rises.” The net exports effect is a substitution, but between countries, not between domestic goods.

Movements along AD versus shifts of AD

This distinction is tested constantly. The question to ask is always: has the price level changed, or has something else?

A change in the price level causes a movement along the existing AD curve, through the three effects above.
A change in anything else that affects C, I, G or (X − M) shifts the whole curve, because planned spending is now different at every price level.

For example, a tax cut raises consumption at every price level, so AD shifts right. A fall in the price level also raises consumption, through the wealth effect, but that is a movement along AD. Likewise, interest rates set by the central bank shift AD, while interest rates that fall because the price level fell are part of the slope.

What shifts each component

Component	Shifts AD right when…	Note
Consumption (C)	Confidence rises, house or share prices rise, income tax is cut, credit gets easier, household debt falls	The largest component; expectations matter a lot
Investment (I)	Business confidence (“animal spirits”) rises, real interest rates fall, corporate tax is cut, new technology appears, expected demand rises	The most volatile: US investment fell about 25% in 2007–09 while consumption fell under 3%
Government spending (G)	The government decides to buy more goods and services	The only part the state controls directly; transfers affect AD only through C
Net exports (X − M)	Foreign incomes grow, the currency depreciates, competitiveness improves	A recession among trading partners shifts AD left

The multiplier

Suppose the government spends $100 million building a bridge. AD rises by $100 million. But the story does not end there. The builders and engineers receive that money as income and spend part of it at car dealers, restaurants and shops. Those businesses receive it as income and spend part of it too. Each round is smaller than the last, but together they add up to much more than the first $100 million. This is the multiplier, Keynes’s most important contribution to macroeconomics.

Key termMarginal propensity to consume (MPC): the fraction of each extra pound of income that is spent on domestic consumption, $ \text{MPC} = \dfrac{\Delta C}{\Delta Y} $.

Key termLeakages (withdrawals): income that is not passed on as domestic spending, through saving (MPS), tax (MPT) or imports (MPM); bigger leakages mean a smaller multiplier.

In a simple closed economy with no taxes, MPC + MPS = 1. In an open economy with taxes, the MPC and the three leakages add up to 1.

\[ k = \frac{1}{1 – \text{MPC}} \qquad \text{or} \qquad k = \frac{1}{\text{MPS} + \text{MPT} + \text{MPM}} \qquad \Delta Y = k \times \Delta(\text{injection}) \]

Worked example

A closed economy with no taxes has MPC = 0.75. Investment rises by $40 billion. Find the multiplier, the first three rounds of spending and the total change in real GDP.

Step 1$ k = \dfrac{1}{1 – 0.75} = \dfrac{1}{0.25} = 4 $

Step 2$ \text{Rounds: } 40, \quad 0.75 \times 40 = 30, \quad 0.75 \times 30 = 22.5, \ \ldots $

Step 3$ \Delta Y = 4 \times 40 = \$160\text{bn} $

Each round is 75% of the one before. The rounds keep shrinking but add up to $160 billion, four times the initial injection.

Worked example

Now a realistic open economy. Out of each extra pound, households save 0.15, pay 0.25 in tax and spend 0.10 on imports. The government cuts spending by £30 billion. What happens to real GDP?

Step 1$ \text{Leakages} = 0.15 + 0.25 + 0.10 = 0.50 $

Step 2$ k = \dfrac{1}{0.50} = 2 $

Step 3$ \Delta Y = 2 \times (-30) = -£60\text{bn} $

Real GDP falls by £60 billion. The multiplier works just as strongly in reverse, which is why spending cuts during a recession are so controversial.

How big is the multiplier in real life?

The formula is simple, but the real-world size of the multiplier is one of the most important arguments in economics. It changes with conditions.

The multiplier is larger when:

there is lots of spare capacity, so extra demand raises output rather than prices;
interest rates are at the zero lower bound, so the central bank cannot cancel the stimulus by raising rates;
the money goes to low-income households, who spend nearly all of any extra income (a high MPC);
little of the spending leaks abroad as imports.

It is smaller when:

the economy is at full employment, so extra demand mostly raises prices;
the central bank raises rates in response;
government borrowing pushes up interest rates and crowds out private investment;
people expect higher future taxes and save the stimulus instead (Ricardian equivalence), which holds in theory but only partly in practice.

This mattered enormously in Europe after 2010. Austerity plans were built on an assumed multiplier of about 0.5. In 2013, IMF economists Olivier Blanchard and Daniel Leigh showed the true value had been between 0.9 and 1.7. Greece cut spending sharply, its economy shrank by about 25%, and its debt-to-GDP ratio rose from 146% to 180%, because GDP fell almost as fast as the debt.

Practise: 6 questions

Try each one on paper first, then check the worked answer.

EasyQ1. A closed economy with no taxes has MPC = 0.8. Calculate the MPS and the multiplier. Show worked answer

$ \text{MPS} = 1 – 0.8 = 0.2 $
$ k = \dfrac{1}{1 – 0.8} = \dfrac{1}{0.2} = 5 $

EasyQ2. Movement along AD or shift of AD? (a) the general price level falls; (b) income tax is cut; (c) business confidence collapses. Show worked answer

(a) Movement along AD: only the price level has changed.
(b) Shift right: consumption rises at every price level.
(c) Shift left: investment falls at every price level.

MediumQ3. MPC = 0.6 in a closed economy with no taxes. Investment rises by $20 billion. Show the first four rounds of spending and the total change in real GDP. Show worked answer

Round 1: $20bn. Round 2: $ 0.6 \times 20 = \$12\text{bn} $. Round 3: $ 0.6 \times 12 = \$7.2\text{bn} $. Round 4: $ 0.6 \times 7.2 = \$4.32\text{bn} $.
$ k = \dfrac{1}{1 – 0.6} = \dfrac{1}{0.4} = 2.5 $, so $ \Delta Y = 2.5 \times 20 = \$50\text{bn} $.

MediumQ4. An open economy has MPS = 0.2, MPT = 0.2 and MPM = 0.1. Government spending rises by $50 billion. Calculate the change in real GDP. Show worked answer

Leakages $ = 0.2 + 0.2 + 0.1 = 0.5 $
$ k = \dfrac{1}{0.5} = 2 $
$ \Delta Y = 2 \times 50 = \$100\text{bn} $

MediumQ5. A student writes: “AD slopes down because when the price level falls, goods are cheaper than substitutes, so people buy more.” What is wrong, and what is the correct reasoning? Show worked answer

The student has used the microeconomic substitution effect. When the general price level falls, all domestic prices fall together, so there is nothing cheaper to switch to.
The correct reasons are: the wealth effect (money holdings buy more, so C rises); the interest rate effect (money demand falls, interest rates fall, so I rises); and the net exports effect (domestic goods become cheaper than foreign goods, so X − M rises).

ExamQ6. An open economy has MPS = 0.10, MPT = 0.30 and MPM = 0.20. GDP is $1,200bn and the budget deficit is $96bn. The government cuts spending by $60bn. (a) Calculate the multiplier. (b) Calculate the change in real GDP. (c) If tax revenue falls by MPT × ΔY, calculate the new deficit and comment. [6 marks] Show worked answer

(a) Leakages $ = 0.10 + 0.30 + 0.20 = 0.60 $; $ k = \dfrac{1}{0.60} \approx 1.67 $. [2 marks]
(b) $ \Delta Y = \dfrac{1}{0.60} \times (-60) = -\$100\text{bn} $. GDP falls to $1,100bn. [2 marks]
(c) Tax revenue falls by $ 0.30 \times 100 = \$30\text{bn} $. Net deficit reduction $ = 60 – 30 = \$30\text{bn} $, so the new deficit is $ 96 – 30 = \$66\text{bn} $. The cut reduced the deficit by only half the headline amount, because the contraction destroyed tax revenue. As a share of GDP the deficit fell from $ \tfrac{96}{1{,}200} = 8\% $ to $ \tfrac{66}{1{,}100} = 6\% $. [2 marks]

Check yourself

1. Which is NOT a reason the AD curve slopes downward?

All domestic prices fall together, so there is nothing to substitute towards.

2. With MPC = 0.75 and no taxes or imports, the multiplier is:

k = 1 ÷ (1 − 0.75) = 1 ÷ 0.25 = 4.

3. The fiscal multiplier is likely to be largest when:

Extra demand then raises output rather than prices, and the central bank cannot offset it with higher rates.

Your score: 0 out of 3

The short version

AD = C + I + G + (X − M), drawn against the price level (vertical) and real GDP (horizontal).
AD slopes down because of the wealth, interest rate and net exports effects, not micro substitution.
A price level change moves the economy along AD; anything else that changes C, I, G or (X − M) shifts it. Investment is the most volatile component.
Multiplier: k = 1 ÷ (1 − MPC) = 1 ÷ (MPS + MPT + MPM). It works in both directions.
The real multiplier is bigger in deep recessions with zero interest rates, and smaller at full employment.

This guide covers the core of Chapter 23 of Economics Made Simple. For the full chapter, including the AD and multiplier diagrams, the European austerity case study and 15 exam-style questions with a complete answer key, get the book.