We’ve now seen that to model an entire economy, instead of using a demand curve, we use an aggregate demand curve:
An aggregate demand curve, AD, is downward sloping, but this time we have price level and real GDP on our axes!
Aggregate demand is all the demand for goods and services in an economy – the demand for everything from jelly beans to machinery, even schools and hospitals.
And we can aggregate demand up into its 4 main components using the AD formula:
AD = C (for consumption) + I (for investment) + G (for government spending) + X (for exports) take away M (for imports)
First, we have C, for consumption – this is demand from households, like me and you. When we demand stuff, like playstations or jellybeans – that demand comes under consumption.
Second we have I, for investment: firms also demand stuff, they demand capital goods…for instance, Apple demands hi-tech machinery to produce its iPhones, construction companies demand cranes to produce their houses – all this demand from firms comes under investment.
Third we have G, for government spending! The government also demands stuff – the UK government, for instance, demands hospitals to treat sick patients, and schools to educate students.
And finally, we have X minus M, exports minus imports.
Because foreigners also demand our stuff! In the UK, for instance, we have loads of foreign consumers demanding the exports we sell abroad: our medicines, fighter jets and financial services.
So we also need to include demand for our exports in aggregate demand.
But…we need to take away imports – because when we import stuff, like importing cheese from France, we’re demanding stuff from another country – so demand for imports is leaving our economy.
And that’s why we take away imports.
So, in summary, the formula for aggregate demand is:
The AD formula is AD = C + I + G + (X minus M)
And each letter stands for:
AD = C + I + G + (X – M)
C is consumption, that’s demand from households.
I is investment, that’s demand for capital goods from firms.
G is government spending…that’s demand from…the government!
X is demand for our exports from foreign consumers.
And M is demand for imports from other countries – so demand for imports is leaving our economy, which is why we take it away!
