Aggregate Demand – Why the Economy Sometimes Just... Doesn’t Want to Spend

Aggregate Demand - Why the Economy Sometimes Just... Doesn’t Want to Spend

Welcome to one of the most important concepts in macroeconomics - and one of the most misunderstood: aggregate demand, aka AD.

It sounds fancy, but here’s the big idea: aggregate demand is just a macro version of what we do every day - spending. But not just yours or mine - everyone’s, across the entire economy.

What Is Aggregate Demand?

In simple terms, aggregate demand (AD) is the total planned spending on a country’s goods and services at different price levels in a given time period.

The formula? Classic IB favourite:

AD = C + I + G + (X − M)

That’s:

• C – Consumption (household spending)

• I – Investment (business spending)

• G – Government spending

• X – M – Net exports (exports minus imports)

This is not the same as GDP (which measures what’s actually been produced and spent). AD is what we intend to spend - so if consumers or businesses hold back, GDP might fall short of AD.

Why the AD Curve Slopes Downward

Unlike microeconomics where demand slopes down because of the substitution and income effect, macro’s version is slightly different.

AD slopes downward because:

1. Wealth effect – If prices rise, your income buys less. You feel poorer. You spend less.

2. Interest rate effect – Higher prices = higher demand for money = higher interest rates = less borrowing = less spending.

3. Trade effect – If domestic prices rise, exports fall and imports rise. That lowers net exports.

Put it simply: the higher the average price level, the less everyone wants to spend.

Components of Aggregate Demand

1. Consumption (C)

Consumption is what households spend on goods and services. It’s the largest component of AD, often making up 60–70% of GDP in developed economies.

Real-World Story:

During the 2020 COVID-19 lockdowns, UK and US households stopped spending on restaurants, holidays, and in-person services. Consumption plummeted. In Q2 2020, the UK economy shrank by nearly 20%, the sharpest contraction in 300 years. AD collapsed - mostly due to a collapse in C.

What Shifts Consumption?

• Consumer confidence: During recessions, people save more money and spend less. When confidence rises, so does consumption.

• Interest rates: The Bank of England’s base rate hit 5.25% in 2023, making borrowing (e.g. mortgages, car loans) more expensive - spending dropped.

• Wealth effect: Rising house prices (e.g. UK housing boom 2012–2022) make people feel wealthier and spend more.

• Income taxes: A government tax cut = more disposable income = more spending.

• Household debt: Less debt = more freedom to spend. More debt = repayments take priority.

• Inflation expectations: If people expect prices to rise, they might buy sooner - like toilet roll panic-buying in 2020!

2. Investment (I)

Investment refers to business spending on things like equipment, software, buildings - basically anything that increases productive capacity.

In the UK, business investment was hit hard by Brexit uncertainty. Many firms delayed investment because they weren’t sure what trade rules would apply.

What Shifts Investment?

• Interest rates: High rates make borrowing for investment more expensive.

• Business confidence: High confidence = higher risk-taking and investment.

• Technology: A breakthrough (e.g. AI, automation) prompts firms to upgrade their tech.

• Business taxes: Lower corporation tax boosts post-tax profits, making investment more attractive.

• Corporate debt: High debt = cautious firms.

• Stability: Political or economic instability kills investment. Just ask any firm trying to invest in Argentina during a currency crisis.

3. Government Spending (G)

Government spending is all about the public sector: healthcare, education, defence, infrastructure.

When the UK government launched the furlough scheme in 2020, it spent over £70 billion to support wages. This was a direct injection into AD.

What Shifts G?

• Political priorities: A government focused on public health will spend more on the NHS. A defence-heavy one may focus on military.

• Economic needs: In downturns, governments often increase spending to stimulate AD (Keynesian stimulus).

• Global shocks: Pandemic? Spend more. Financial crisis? Spend more.

4. Net Exports (X − M)

Exports (X) = Foreign demand for domestic goods

Imports (M) = Domestic demand for foreign goods

If exports > imports, net exports are positive. This adds to AD.

Real-World Story:

In 2022, the UK faced rising import costs due to a weak pound and high energy prices. Net exports fell, reducing AD.

What Shifts Net Exports?

• Income abroad: If the EU is in recession, they’ll import less UK wine and tech.

• Exchange rates: A weak pound makes exports cheaper = more demand. A strong pound = imports boom, exports fall.

• Trade policies: Tariffs, quotas, or subsidies can affect import / export flows. Brexit introduced non-tariff barriers that complicated UK-EU trade.

So, What Shifts the AD Curve?

A change in any of the components (C, I, G, or X − M) will shift the entire AD curve:

• Rightward shift (AD increases): More spending at every price level

• Leftward shift (AD decreases): Less spending at every price level

For example:

• A government announces a massive green infrastructure plan (G ↑) → AD shifts right

• Interest rates spike (C and I ↓) → AD shifts left

• China’s economy slows, buying fewer exports from Africa (X ↓) → AD shifts left

Final Thought: AD Is the Pulse of the Economy

Aggregate demand is more than a formula. It’s about how people feel, what businesses believe, and how governments act.

It's driven by:

• Confidence

• Expectations

• Economic policy

• Global conditions

And it reminds us that sometimes, it’s not about how much is produced - but how much people are willing to spend and consume.

Coming next Aggregate Supply - why some economies can’t just “produce more” even if demand is booming and it’s not as easy as turning up the factory dial.