AD measures planned spending on domestic final output.
Aggregate demand is planned expenditure on domestically produced final goods and services at each general price level: AD = C + I + G + X - M. C is household consumption, I is investment in productive capital and inventories, G is government purchases, and X - M is net exports. Imports are deducted because imported content may already appear in C, I or G; this avoids treating foreign production as domestic output. Buying existing financial assets is not itself new productive investment in this expenditure sense. Transfers are not government purchases of current output, although recipients may spend them.
- Planned spending
- Aggregate demand (AD) is planned spending on domestically produced final goods and services at each general price level.
- Components
- AD = C + I + G + X - M. C is household consumption, I investment, G government purchases, X exports and M imports. Exports are foreign purchases of domestic output; imports buy foreign production.
- Investment
- Investment includes new productive capital, such as machinery, and changes in inventories of goods held for later use or sale. Buying an existing company share does not itself create new capital goods.
- Government purchases
- G buys current goods and services. A cash transfer pays money to a recipient without buying output; it may affect consumption when the recipient spends it.
Apply the idea
Domestic final output
Domestic means produced within the economy. Final output is bought for its end use, including investment, rather than as an input to be counted again in another product. The imported part of a purchase is foreign output even when a local buyer pays for it.
Why subtract imports
Imported content can be included in C, I and G. Deducting M avoids counting foreign production as domestic output.
Why AD slopes down
A lower domestic price level makes existing money balances buy more. Under suitable monetary conditions it can also ease interest rates and borrowing, while lower prices relative to foreign goods can encourage net exports. These channels depend on policy, exchange rates and foreign prices; this is not simply buyers switching between two domestic products.
Movement or shift
A change in the general price level moves along a given AD curve. A different spending determinant, such as consumer confidence, can shift it. A rightward shift means more planned spending on domestic output at the same price level; a leftward shift means less.
| Transaction | Treatment | Reason |
|---|---|---|
| Household buys locally produced food | C | Current household consumption of domestic production |
| Firm buys a new imported machine | I with imported content deducted in M | Capital expenditure contains foreign production |
| Government buys current teaching services | G | Purchase of a current service |
| Government pays a cash transfer | Not directly G | Does not itself buy current output |
| Foreign visitor buys a local hotel service | X | Foreign demand for a domestically produced service |
| Investor buys an existing share | Not itself I in AD | Financial ownership changes rather than new capital production |
Worked example: Which spending buys domestic output?
During one period, a simplified economy has C = 500, I = 120, G = 180, X = 150 and M = 100, all in the same currency units. C includes imported household goods. A government cash transfer is not included in G.
- Planned expenditure on domestic output is 500 + 120 + 180 + 150 - 100 = 850.
- The subtraction of imports corrects for foreign output inside the spending categories. It is not an assertion that all imports are economically harmful.
- A purchase of a new factory machine is investment; buying an existing company share is a financial transaction rather than directly adding current output.
- Government purchase of teaching services enters G. A cash transfer first changes the recipient's resources and may affect C when it is spent.
Watch out for this
Every dollar spent by the government is directly a dollar of G in AD.
G here measures purchases of current goods and services. Transfers can affect consumption indirectly but are not themselves purchases of output.
Check your understanding
A government pays a household a cash transfer, which the household saves initially. What is the immediate classification?
- It is automatically government purchases of output.
- It is a transfer, with no immediate consumption purchase in this scenario.
- It is an export.