3.1 Aggregate Demand (AD)

The AD–AS graph has the price level (PL) on the vertical axis and real GDP (real output, Y) on the horizontal axis. Don't label them "price" and "quantity"; this is the whole economy, not one market. The AD curve slopes downward: at a lower price level, the total quantity of real output demanded is higher.

AD is made of the same four parts as GDP: AD = C + I + G + Xn, which stands for consumption, investment, government spending and net exports.

The reason isn't the one from 1.4 (switching to cheaper goods), because when the whole price level falls there's nothing cheaper to switch to. Instead, AD slopes down because of three effects. Each one starts with a lower price level and ends with more spending.

• Real wealth effect: when the price level falls, the money and savings people already hold can buy more. Feeling richer in real terms, households spend more, so C rises.
• Interest rate effect: when the price level falls, people and firms need less money to make their usual purchases, so they want to hold less of it and put more into savings and lending. That pushes interest rates down, which makes borrowing cheaper, so business investment (I) and interest-sensitive consumer spending, like car purchases, rise.
• Exchange rate effect: when the price level falls, this country's goods become cheaper compared with foreign goods. Foreign buyers purchase more exports and local buyers purchase fewer imports, so net exports (Xn) rise. Some textbooks explain this effect through lower interest rates and a weaker currency; either way, net exports rise.

A change in the price level moves the economy along the AD curve. It changes the quantity of real output demanded, not AD itself.

Anything else that changes C, I, G or Xn shifts the whole curve: right for an increase (AD1 to AD2), left for a decrease.

• Consumption (C): consumer confidence and expectations, household wealth (a stock-market or housing boom raises it), household debt, and taxes or transfer payments.
• Investment (I): business expectations of future sales, interest rates changed by the central bank (not by the price level), business taxes, and new technology that makes new equipment worth buying.
• Government spending (G): purchases of goods and services, from roads to military equipment to teachers' salaries.
• Net exports (Xn): incomes in other countries (richer foreigners buy more exports), the exchange rate (a stronger dollar makes exports pricier and imports cheaper, so Xn falls), and foreign tastes for this country's goods.

A change in interest rates can be either a movement or a shift, depending on the cause. If interest rates change because the price level changed, that's the interest rate effect, a movement along AD. If the central bank lowers interest rates (4.6), investment rises at every price level, so AD shifts right. Read what caused the change.