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IB DP Economics — Unit 3: Macroeconomics | SL | 3.2 Variations in Economic Activity — Aggregate Demand and Aggregate Supply
📋 What You Will Learn
- Define aggregate demand (AD) and state the AD equation
- Explain why the AD curve is downward-sloping using three distinct effects
- Identify and analyse the four components of AD: consumption (C), investment (I), government expenditure (G), and net exports (X−M)
- Explain the determinants of each component and how they shift the AD curve
- Apply AD analysis to real-world macroeconomic events and policy decisions
- Evaluate the relative importance of each component in determining the level of aggregate demand
🔍 Guiding Question What determines the total level of spending in an economy, and why does it matter for output, employment, and the price level?
🌍 Why This Matters In 2023, the United States economy defied expectations of recession: consumer spending remained resilient, government infrastructure investment surged under the Inflation Reduction Act, and GDP grew at 3.1% in Q3. Meanwhile, Germany fell into recession as export demand collapsed and business investment dried up. Two advanced economies, same global environment — opposite outcomes. The difference lay in the composition and strength of their aggregate demand.
What Is Aggregate Demand?
In microeconomics, demand refers to the willingness and ability of consumers to buy a single good at various prices. In macroeconomics, we need a concept that captures the total spending in an entire economy. That concept is aggregate demand.
📖 Definition — Aggregate Demand (AD) Aggregate demand is the total spending on an economy's goods and services at different price levels over a given time period, ceteris paribus. It represents the sum of all planned expenditures in the economy.
AD is measured as the sum of four components. This relationship is captured in the national expenditure identity, which is both a definition and a framework for macroeconomic analysis.
The AD Equation
\[ AD = C + I + G + (X - M) \] Where: \(C\) = household consumption, \(I\) = business investment, \(G\) = government expenditure, \(X\) = exports, \(M\) = imports, and \((X - M)\) = net exports.
📌 Important Clarification The AD equation is an identity — it is true by definition. Every unit of output produced is either consumed, invested, purchased by government, or exported (net of imports). It is not a behavioural equation predicting what people will spend; it is an accounting framework for measuring total expenditure.
The AD Curve: Shape and Explanation
The AD curve plots the relationship between the overall price level of an economy and the total quantity of real output (real GDP) that all sectors plan to purchase. It slopes downward — but the reason is fundamentally different from why a microeconomic demand curve slopes downward.
⚠️ Critical Distinction — Why AD Slopes Downward The AD curve does NOT slope downward because of the substitution effect or income effect (those explain individual demand curves). At the macro level, when the price level rises, the entire basket of goods becomes more expensive — there is no substitute for "the economy." The three correct explanations are below.
Three Reasons the AD Curve Slopes Downward
- The wealth effect (real balance effect): a higher price level reduces the real value of households' money holdings and financial assets. Consumers feel less wealthy and reduce spending (C falls) → AD falls.
- The interest rate effect: a higher price level increases the demand for money (people need more money to buy the same goods). With a fixed money supply, interest rates rise. Higher interest rates discourage borrowing for consumption and investment (C and I fall) → AD falls.
- The international trade effect (exchange