3.2.3 Determinants of AD components Notes

1. The Price Level (PL) of an economy is not the only factor that affects its aggregate demand (AD).
2. While changes in the PL cause movements along the AD curve, changes in the determinants of the AD components (C+I+G+(X-M)) shift the AD curve.

The determinants of AD components covered in the IB curriculum are:

1. Consumer spending (C) determinants:
   1. Consumer confidence.
   2. Interest rates.
   3. Wealth.
   4. Income taxes.
   5. Level of household indebtedness.
   6. Expectations of future price level.
2. Investment (I) determinants:
   1. Interest rates.
   2. Business confidence.
   3. Technology.
   4. Business taxes.
   5. Level of corporate indebtedness.
3. Government spending (G) determinants:
   1. Political and economic priorities.
4. Net exports (X-M) determinants:
   1. Income of trading partners.
   2. Exchange rates.
   3. Trade policies.

Note

The most important thing to note in this topic is that:

1. Changes in price level cause changes the quantity of real GDP demanded (causing a movement along the AD curve).
2. Changes in the determinants of AD components lead to changes in the quantity of real GDP demanded at all possible price levels (causing a shift of the demand curve).
   1. A rightward shift indicates that at all given price levels, the total quantity of real GDP demanded increases.
   2. A leftward shift indicates that at all given price levels, the total quantity of real GDP demanded decreases.

Consumer spending (C) determinants

Consumer confidence

Increased consumer confidence → rightward shift in AD

1. Consumer confidence refers to the level of optimism consumers feel about the economy's overall condition and their personal financial situation.
2. If an event causes consumers to feel more confident about the economy's condition or their personal financial situation, consumer confidence increases.
3. Increased consumer confidence causes consumers to increase their spending, since they are confident in the economic conditions.
4. Since consumer spending is one of the components of AD, higher consumer spending leads to higher AD at all price levels.
5. Resultantly, an increase in consumer confidence shifts the AD curve to the right (AD1→AD2).

Decreased consumer confidence → leftward shift in AD

1. Consumer confidence refers to the level of optimism consumers feel about the economy's overall condition and their personal financial situation.
2. If an event causes consumers to feel less confident about the economy's condition or their personal financial situation, consumer confidence decreases.
3. Decreased consumer confidence causes consumers to reduce their spending, as they feel uncertain or pessimistic about the economic conditions and want to retain their financial resources.
4. Since consumer spending is one of the components of AD, lower consumer spending leads to lower AD at all price levels.
5. Resultantly, a decrease in consumer confidence shifts the AD curve to the left (AD1→AD2).

Interest rates

Increased interest rates → leftward shift in AD

1. Interest rates refer to the cost of borrowing money or the reward for saving.
2. If interest rates rise, borrowing becomes more expensive for consumers, while the incentive to save increases.
3. Hence, increased interest rates discourage consumers from spending, as they have a higher incentive to save.
4. Since consumer spending is a component of AD, lower spending leads to lower AD at all price levels.
5. Resultantly, an increase in interest rates shifts the AD curve to the left (AD1→AD2).

Decreased interest rates → rightward shift in AD

1. Interest rates refer to the cost of borrowing money or the reward for saving.
2. If interest rates fall, borrowing becomes cheaper for consumers, while the incentive to save decreases.
3. Hence, decreased interest rates encourage consumers to spend, as the as the cost of financing is lower.
4. Since consumer spending is a component of AD, higher spending leads to higher AD at all price levels.
5. Resultantly, an decrease in interest rates shifts the AD curve to the right (AD1→AD2).

Wealth

Increased wealth → rightward shift in AD

1. Wealth refers to the total value of a household’s assets, such as property, stocks, and savings, minus liabilities.
2. When wealth increases, consumers feel more financially secure and confident about their economic situation.
3. This encourages higher consumer spending, as households are willing to use their additional wealth to buy goods and services.
4. Since consumer spending is a component of AD, increased spending leads to higher AD at all price levels.
5. Resultantly, an increase in wealth shifts the AD curve to the right (AD1→AD2).

Decreased wealth → leftward shift in AD

1. Wealth refers to the total value of a household’s assets, such as property, stocks, and savings, minus liabilities.
2. When wealth decreases, consumers feel less financially secure and more uncertain about their economic situation.
3. This discourages consumer spending, as households may cut back on expenditures to compensate for the loss in wealth.
4. Since consumer spending is a component of AD, reduced spending leads to lower AD at all price levels.
5. Resultantly, a decrease in wealth shifts the AD curve to the left (AD1→AD2).

Income taxes

Increased income taxes → leftward shift in AD

1. Income taxes refer to taxes imposed by the government on households' incomes, which reduce disposable income.
2. When income taxes increase, consumers have less disposable income to spend on goods and services.
3. This discourages consumer spending, as households need to allocate more of their income to tax payments and less to consumption.
4. Since consumer spending is a component of AD, lower spending leads to lower AD at all price levels.
5. Resultantly, an increase in income taxes shifts the AD curve to the left (AD1→AD2).

Decreased income taxes → rightward shift in AD

1. Income taxes refer to taxes imposed by the government on households' incomes, which reduce disposable income.
2. When income taxes decrease, consumers have more disposable income to spend on goods and services.
3. This encourages higher consumer spending, as households retain (and can spend) a greater share of their income.
4. Since consumer spending is a component of AD, higher spending leads to higher AD at all price levels.
5. Resultantly, a decrease in income taxes shifts the AD curve to the right (AD1→AD2).

Level of household indebtedness

Increased household indebtedness → leftward shift in AD

1. Household indebtedness refers to the total amount of debt that households owe, such as mortgages, credit card debt, and loans.
2. When an even causes household indebtedness to increase, consumers allocate more of their income toward repaying debt and less of it on spending on goods and services.
3. This reduces consumer spending, as households prioritise debt repayments over consumption.
4. Since consumer spending is a component of AD, lower spending leads to lower AD at all price levels.
5. Resultantly, an increase in household indebtedness shifts the AD curve to the left (AD1→AD2).

Decreased household indebtedness → rightward shift in AD

1. Household indebtedness refers to the total amount of debt that households owe, such as mortgages, credit card debt, and loans.
2. When an even causes household indebtedness to decrease, consumers allocate less of their income toward repaying debt, leaving more income available for spending.
3. This increases consumer spending, as households feel less constrained by debt obligations.
4. Since consumer spending is a component of AD, higher spending leads to higher AD at all price levels.
5. Resultantly, an decrease in household indebtedness shifts the AD curve to the right (AD1→AD2).

Expectations of future price level

Expectations of higher future prices → rightward shift in AD

1. Expectations of future price levels refer to what consumers anticipate about how prices will change in the future.
2. If consumers expect prices to rise in the future, they are likely to increase their spending now to avoid paying higher prices later.
3. This causes an increase in current consumer spending, which is a component of AD.
4. Since consumer spending is a component of AD, higher spending leads to higher AD at all price levels.
5. Resultantly, expectations of higher future prices shift the AD curve to the right (AD1→AD2).

Expectations of lower future prices → leftward shift in AD

1. Expectations of future price levels refer to what consumers anticipate about how prices will change in the future.
2. If consumers expect prices to fall in the future, they are likely to decrease their spending now hoping to pay lower prices later.
3. This causes a decrease in current consumer spending, which is a component of AD.
4. Since consumer spending is a component of AD, lower spending leads to lower AD at all price levels.
5. Resultantly, expectations of lower future prices shift the AD curve to the left (AD1→AD2).

Investment (I) determinants

Interest rates

Increased interest rates → leftward shift in AD

1. Interest rates refer to the cost of borrowing money or the reward for saving.
2. If interest rates rise, borrowing becomes more expensive for business.
3. Hence, increased interest rates make investing in new projects or capital equipment less attractive for firms. Additionally, higher interest rates encourage businesses to save rather than spend on investments.
4. Since firms investment is a component of AD, lower investment leads to lower AD at all price levels.
5. Resultantly, an increase in interest rates shifts the AD curve to the left (AD1→AD2).

Decreased interest rates → rightward shift in AD

1. Interest rates refer to the cost of borrowing money or the reward for saving.
2. If interest rates fall, borrowing becomes cheaper for business.
3. Hence, decreased interest rates make investing in new projects or capital equipment more attractive for firms. Additionally, lower interest rates reduce the incentive to save, making spending on investments more attractive for businesses.
4. Since firms investment is a component of AD, higher investment leads to higher AD at all price levels.
5. Resultantly, a decrease in interest rates shifts the AD curve to the right (AD1→AD2).

Business confidence

Increased business confidence → rightward shift in AD

1. Business confidence refers to the level of optimism that firms have about the economy's future performance and profitability.
2. If an event causes businesses to feel more optimistic about future economic conditions, business confidence increases.
3. Increased businesses confidence causes businesses to increase their investments in new projects, equipment, and expansion, since they are confident about future profitability.
4. Since investment is one of the components of AD, higher firm investment spending leads to higher AD at all price levels.
5. Resultantly, an increase in businesses confidence shifts the AD curve to the right (AD1→AD2).

Decreased business confidence → leftward shift in AD

1. Business confidence refers to the level of optimism that firms have about the economy's future performance and profitability.
2. If an event causes businesses to feel less optimistic about future economic conditions, business confidence decreases.
3. Decreased businesses confidence causes businesses to decrease their investments in new projects, equipment, and expansion, since they are less confident about future profitability.
4. Since investment is one of the components of AD, lower firm investment spending leads to lower AD at all price levels.
5. Resultantly, a decrease in businesses confidence shifts the AD curve to the left (AD1→AD2).

Technology

Technological advancements → rightward shift in AD

1. Technological advancement refers to the development and application of innovations that improve productivity and efficiency in production processes.
2. If technological advancements occur, firms can produce goods and services more efficiently, reducing production costs and increasing profitability.
3. This encourages firms to increase investment spending in adopting and implementing new technology.
4. Since investment is a component of AD, higher investment spending leads to higher AD at all price levels.
5. Resultantly, an improvement in technology shifts the AD curve to the right (AD1→AD2).

Technological stagnation → leftward shift in AD

1. Technological advancement refers to the development and application of innovations that improve productivity and efficiency in production processes.
2. If technological stagnation occurs, where there is little to no advancement in technology, firms may experience higher production costs and reduced productivity.
3. This discourages firms from investing in new projects or equipment, as the lack of innovation limits potential profitability.
4. Since investment is a component of AD, lower investment spending leads to lower AD at all price levels.
5. Resultantly, a lack of technological progress shifts the AD curve to the left (AD1→AD2).

Business taxes

Higher business taxes → leftward shift in AD

1. Business taxes refer to taxes imposed on firms' income, profits, or production by the government.
2. If business taxes increase, firms face higher operational costs, since a greater part of their revenue needs to be allocated to paying the business taxes.
3. This discourages firms from spending on new investments, as higher taxes lower profitability.
4. Since investment is a component of AD, lower investment spending leads to lower AD at all price levels.
5. Resultantly, an increase in business taxes shifts the AD curve to the left (AD1→AD2).

Lower business taxes → rightward shift in AD

1. Business taxes refer to taxes imposed on firms' income, profits, or production by the government.
2. If business taxes decrease, firms face lower operational costs, since a smaller part of their revenue needs to be allocated to paying the business taxes.
3. This encourages firms to allocate their spare revenue to increase their investment spending in equipment, infrastructure, or other productive ventures.
4. Since investment is a component of AD, higher investment spending leads to higher AD at all price levels.
5. Resultantly, a reduction in business taxes shifts the AD curve to the right (AD1→AD2).

Level of corporate indebtedness

Higher corporate indebtedness → leftward shift in AD

1. Corporate indebtedness refers to the level of debt that firms have accumulated through borrowing.
2. If corporate indebtedness is high, firms must allocate a larger portion of their resources toward debt repayment, reducing funds available for new investments.
3. This discourages firms from spending on investments, as they focus on managing their existing financial obligations.
4. Since investment is a component of AD, lower investment spending leads to lower AD at all price levels.
5. Resultantly, a higher level of corporate indebtedness shifts the AD curve to the left (AD1→AD2).

Lower corporate indebtedness → rightward shift in AD

1. Corporate indebtedness refers to the level of debt that firms have accumulated through borrowing.
2. If corporate indebtedness is low, firms have fewer financial obligations to repay, leaving them with more resources to invest in new projects, equipment, or expansion.
3. This encourages firms to increase their investment spending, as they are in a better financial position to take on new ventures.
4. Since investment is a component of AD, higher investment spending leads to higher AD at all price levels.
5. Resultantly, a lower level of corporate indebtedness shifts the AD curve to the right (AD1→AD2).

Government spending (G) determinants

Political and economic priorities

Increased government spending due to political/economic priorities → rightward shift in AD

1. Government spending (G) refers to expenditures by the government on goods and services, including infrastructure, education, and healthcare.
2. When political or economic priorities shift toward increased government spending (funding public projects, social programs, or economic stimulus packages...), government expenditure rises.
3. Since government spending (G) is a component of AD, increased in government spending leads to higher aggregate demand (AD) at all price levels.
4. Resultantly, increased government spending due to political or economic priorities shifts the AD curve to the right (AD1→AD2).

Decreased government spending due to political/economic priorities → leftward shift in AD

1. Government spending (G) refers to expenditures by the government on goods and services, including infrastructure, education, and healthcare.
2. When political or economic priorities shift toward decreased government spending (implementing austerity measures, ideological reasons...), government expenditure falls.
3. Since government spending (G) is a component of AD, a decrease in government spending leads to lower aggregate demand (AD) at all price levels.
4. Resultantly, decreased government spending due to political or economic priorities shifts the AD curve to the left (AD1→AD2).

Net exports (X-M) determinants

Income of trading partners

Increased income of trading partners → rightward shift in AD

1. The income of trading partners refers to the income of the countries that import goods and services from the domestic economy.
2. When the income of trading partners increases, their ability to purchase imports from the domestic economy rises.
3. This leads to higher exports (X) for the domestic economy, which increases net exports (X - M) as imports are assumed to remain unchanged.
4. Since net exports are a component of aggregate demand (AD), higher net exports result in an increase in AD at all price levels.
5. Resultantly, an increase in the income of trading partners shifts the AD curve to the right (AD1→AD2).

Decreased income of trading partners → leftward shift in AD

1. The income of trading partners refers to the income of the countries that import goods and services from the domestic economy.
2. When the income of trading partners decreases, their ability to purchase imports from the domestic economy falls.
3. This leads to lower exports (X) for the domestic economy, which decreases net exports (X - M) as imports are assumed to remain unchanged.
4. Since net exports are a component of aggregate demand (AD), lower net exports result in a decrease in AD at all price levels.
5. Resultantly, a decrease in the income of trading partners shifts the AD curve to the left (AD1→AD2).

Exchange rates

Appreciation of the domestic currency → leftward shift in AD

1. Exchange rates refer to the value of one currency in terms of another.
2. When the domestic currency appreciates, the same amount of domestic is equivalent to a greater amount of the foreign currency.
3. Therefore, imports become cheaper, encouraging their purchase by domestic consumers. At the same time, the price of domestic exports for foreigners increases, making them more expensive and decreasing their demand.
4. As a result, exports (X) decrease and imports (M) increase, leading to a decrease in net exports (X - M).
5. Since net exports are a component of aggregate demand (AD), lower net exports result in a decrease in AD at all price levels.
6. Resultantly, an appreciation of the domestic currency shifts the AD curve to the left (AD1→AD2).

Depreciation of the domestic currency → rightward shift in AD

1. Exchange rates refer to the value of one currency in terms of another.
2. When the domestic currency depreciates, the same amount of domestic is equivalent to a lesser amount of the foreign currency.
3. Therefore, imports become more expensive, discouraging their purchase by domestic consumers. At the same time, the price of domestic exports for foreigners decreases, making them cheaper and increasing their demand.
4. As a result, exports (X) increase and imports (M) decrease, leading to an increase in net exports (X - M).
5. Since net exports are a component of aggregate demand (AD), higher net exports result in an increase in AD at all price levels.
6. Resultantly, a depreciation of the domestic currency shifts the AD curve to the right (AD1→AD2).

Trade policies

Trade liberalisation → rightward shift in AD

1. Trade policies refer to government regulations that influence international trade, such as tariffs, quotas, or free trade agreements.
2. When a country reduces trade barriers (lowers tariffs, removes import quotas...), it encourages greater trade activity.
3. Greater trade activity may alter the net exports (X-M) positively or negatively, depending on the measures take by the government.
   1. If (X-M) increases, since net exports are a component of aggregate demand (AD), increased net exports result in a higher AD at all price levels. This causes a shift to the right of the AD curve.
   2. If (X-M) decreases, since net exports are a component of aggregate demand (AD), decreased net exports result in a lower AD at all price levels. This causes a shift to the left of the AD curve.