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The aggregate demand (AD) curve shows the total quantity of goods and services that households, firms, government, and foreigners wish to purchase at each price level. It slopes downward because a lower price level increases real wealth (wealth effect), lowers interest rates stimulating investment (interest rate effect), and makes domestic goods cheaper relative to foreign goods (exchange rate effect). The AD curve shifts when any component of C, I, G, or NX changes for reasons other than the price level.
List every determinant of each component (C, I, G, NX) and classify whether an increase shifts AD right or left. Practice: 'Consumer confidence rises — what happens to AD and why?' Distinguish movements along AD from shifts of AD.
From GDP components, you know that real output Y = C + I + G + NX. The aggregate demand curve asks: for each possible price level, what total quantity of goods and services would all buyers in the economy want to purchase? The result is a downward-sloping relationship between the price level and real output demanded — but for entirely different reasons than a standard demand curve. In microeconomics, demand slopes down because higher prices cause substitution to other goods. At the macroeconomic level, there are no "other goods" — we're already looking at everything. The downward slope comes from three distinct mechanisms that link the price level to spending.
The wealth effect works through real money balances. If the price level falls, your fixed nominal holdings of currency and deposits are worth more in real terms — your purchasing power rises, so consumption spending increases. The interest rate effect is stronger and more direct: a lower price level reduces the demand for money (you need less nominal money to buy the same real goods), which pushes interest rates down, which stimulates investment spending I. The exchange rate effect links to your future study of exchange rates: a lower domestic price level makes domestic goods cheaper relative to foreign goods, boosting net exports NX. All three mechanisms increase the quantity of real output demanded when the price level falls, generating the downward-sloping AD curve.
The crucial discipline — which you learned from supply and demand — is distinguishing movements along the curve from shifts of the curve. The price level changing causes movement along the AD curve (the three effects just described). Everything else — policy changes, shifts in consumer confidence, foreign income changes, changes in investment sentiment — shifts the entire AD curve. A $200 billion increase in government spending G shifts AD right by more than $200 billion due to the fiscal multiplier: that $200B becomes income for contractors, who spend a fraction on consumption, which becomes income for others, and so on. The multiplier is 1/(1-MPC) in the simplest model, so a marginal propensity to consume of 0.75 implies a multiplier of 4 — the full AD shift is $800 billion from the original $200B injection.
Understanding what shifts AD — and by how much — is the foundation of macroeconomic policy analysis. The fiscal multiplier connects G changes to output. Monetary policy works primarily through the interest rate effect: lower rates stimulate I and rate-sensitive consumption (housing, durables), shifting AD right. Consumer and business confidence, which you can't observe directly but can proxy through survey data, shifts C and I. And the international linkages through exchange rates and foreign income connect domestic AD to the global economy. The IS-LM model, which you'll study next, provides the formal framework for tracing all these interactions simultaneously.