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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 identify its four components using the national income expenditure equation
- Explain the determinants of each AD component and how changes in these determinants shift the AD curve
- Analyse the shape and slope of the AD curve and distinguish it from a microeconomic demand curve
- Apply the AD framework to real-world economic events such as recessions, booms, and policy changes
- Evaluate the relative significance of different AD components in driving economic fluctuations
🔍 Guiding Question What determines the total level of spending in an economy, and why does it fluctuate — causing economies to expand, contract, and cycle through booms and recessions?
🌍 Why This Matters In 2023, the United States economy defied predictions of recession: consumer spending remained robust, government stimulus continued to flow, and GDP grew at 2.5% — even as interest rates hit a 22-year high. Meanwhile, Germany slipped into technical recession as business investment collapsed and export demand from China weakened. Two economies, same global conditions, opposite outcomes — because the determinants of their aggregate demand moved in opposite directions.
What Is Aggregate Demand?
In microeconomics, demand refers to the quantity of a single good consumers wish to buy at different prices. In macroeconomics, we zoom out to ask: what is the total level of spending on all goods and services in an entire economy at different price levels? This is aggregate demand.
📖 Definition — Aggregate Demand (AD) Aggregate demand is the total spending on an economy's goods and services at different average price levels in a given time period. It is the sum of all planned expenditures by all sectors of the economy.
The Expenditure Equation
\[ AD = C + I + G + (X - M) \] Where: \( C \) = household consumption, \( I \) = investment by firms, \( G \) = government spending, \( X \) = exports, \( M \) = imports, and \( (X - M) \) = net exports (also written NX).
Each of these four components has its own set of determinants — factors that cause spending in that category to rise or fall. When any component increases, AD shifts rightward (increases). When any component falls, AD shifts leftward (decreases).
The AD Curve — Shape and Slope
The AD curve plots the relationship between the average price level (on the vertical axis) and the total real output (real GDP) that all sectors of the economy wish to purchase (on the horizontal axis). It slopes downward — but for reasons entirely different from a microeconomic demand curve.
📖 Definition — The AD Curve The AD curve shows the inverse relationship between the average price level and the real GDP that all sectors of the economy plan to spend on, ceteris paribus. It slopes downward from left to right.
Why Does the AD Curve Slope Downward?
- The wealth effect (real balance effect): a higher price level reduces the real value of household wealth and savings — people feel poorer and reduce consumption (C falls)
- The interest rate effect: a higher price level increases the demand for money (people need more money for transactions), pushing up interest rates — this reduces investment (I falls) and consumption of credit-financed goods (C falls)
- The international trade effect: a higher domestic price level makes exports more expensive for foreigners and imports cheaper for domestic consumers — net exports fall (X − M falls)
⚠️ Critical Distinction — AD Curve vs Microeconomic Demand Curve
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