There are four components of Aggregate Demand (AD); Consumption (C), Investment (I), Government Spending (G) and Net Exports (X-M). Aggregate Demand shows the relationship between Real GNP and the Price Level.
AD = C + I + G + (X-M)
Four Components of Aggregate Demand
Any increase in any of the four components of aggregate demand leads to an increase or shift in the aggregate demand curve as seen in the diagram above.
This is made by households, and sometimes consumption accounts for the larger portion of aggregate demand. An increase in consumption shifts the AD curve to the right.
Factors that Affect Consumption
If consumers are confident about their future income, job stability, and the economy is growing and stable, spending is likely to increase. However, any job insecurity and uncertainty over income is likely to delay spending. An increase in consumer confidence shifts AD to the right.
Lower interest rates tend to increase consumption because larger goods are usually purchased on credit and if interest rates are low, then its cheaper to borrow. Consumers mostly borrow to buy houses, which is one of the biggest purchases and lower interest rates means lower mortgage payments, so households can spend more on other goods. Some Economists argue that lower interest rates also make saving less attractive, but there is no real evidence. So, lower interest rates increase Aggregate Demand.
If a consumer has a lot of debt, he is unlikely to buy more since he would have to pay his debt off first. Low consumer debt increases consumption and aggregate demand.
Wealth are assets held by a household, such as property or stocks. An increase in property is likely increase to consumption.
Investment, second of the four components of aggregate demand, is spending by firms on capital, not households. Investment is the most volatile component of AD. An increase in investment shifts AD to the right in the short run and helps improve the quality and quantity of factors of production in the long run.
Factors that Affect Investment:
Firms borrow from banks to make large capital intensive purchases, and if the interest rate decreases, it becomes cheaper for firms to invest and provides incentive for firms to take risk.
If firms are confident about the economy and its future growth, they are more likely to invest in capital, new projects and buildings/machinery.
If governments provide incentives such as tax breaks, subsidies, loans at lower interest rates then investment can increase. However, corruption and bureaucracy deters investment.
As firms increase output, they would need to invest in new machines. This relationship is known as The Accelerator. The assumption behind the accelerator is that firms will want to main a fixed capital to output ratio, meaning that if a factory uses one machine to produce 1000 goods, and the firms needs to produce 3000 goods more, then the firm will buy 3 more machines.
Government spending forms a large total of aggregate demand, and an increase in government spending shifts aggregate demand to the right. Government spending is categorized into transfer payments and capital spending. Transfer payments include pensions and unemployment benefits and capital spending is on things like roads, schools and hospitals. Governments spend to increase the consumption of health services, education and to re-distribute income. They may also spend to increase aggregate demand.
Imports are foreign goods bought by consumers domestically, and exports are domestic goods bought abroad. Net exports is the difference between exports and imports, and this component can be net imports too, if imports are greater than exports. An increase in net exports shifts aggregate demand to the right. The exchange rate and trade policy affects net exports.