Main components of aggregate demand

There are four principal aggregate demand components. They are Consumption (C), Investment (I),

Government Spending (G) and Net Exports (X-M). Any increase in any of the four components of
aggregate demand leads to an increase or shift in the aggregate demand curve.
AD = C + I + G + (X-M)

Consumption
This is made by households, and sometimes consumption accounts for the larger portion of aggregate
demand.
1. Consumer Confidence
If consumers are confident about their future income, job stability, and the economy is growing and
stable, consumer spending is likely to increase. However, any job insecurity and uncertainty over income
is likely to delay spending.

2. Interest Rates
Lower interest rates tend to increase consumption because consumers purchase larger goods on credit. If
interest rates are low, then it’s 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 that households can
spend more on other goods.

3. Consumer Debt
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.

4. Wealth
Wealth is assets held by a household, such as property or stocks. An increase in property is likely increase
to consumption.

Investment

Investment, second of the four components of aggregate demand, is spending by firms on

capital, not households.

1. Interest Rates
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 an incentive for firms to take
on risk.
2. Business Confidence
If firms are confident about the economy and its future growth, they are more likely to
invest in capital, new projects, and buildings/machinery.

3. Investment Policy
If governments provide incentives such as tax breaks, subsidies, loans at lower interest rates
then investment can increase. However, corruption and bureaucracy deters investment.

4. National Income
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.