The total demand in the economy for goods and services is called the aggregate demand and it is made up of several components of the circular flow.

Aggregate demand (AD) consists of four components:

Consumption (C):

This is also known as consumer expenditure. It consists of spending by households on goods and services.

Investment (I):

This is spending by private sector firms on capital goods.

Government spending (G):

This covers government spending on goods and services.

Net exports (X–M):

This is the difference between the value of exports of goods and services and the value of imports of goods and services.

Thus

AD = C + I + G + X − M

Why does aggregate demand fall when the price level rises and vice versa? There are three reasons:

The wealth effect:

A rise in the price level will reduce the amount of goods and services that people’s wealth can buy. The purchasing power of savings held in the form of bank accounts and other financial assets will fall.

The international effect:

A rise in the price level will reduce demand for net exports as exports will become less price competitive while imports will become more price competitive.

The interest rate effect:

A rise in the price level will increase demand for money to pay the higher prices. This, in turn, will increase the interest rate. A higher interest rate usually results in a reduction in consumption and investment.