Aggregate Demand

The total demand for finished goods and services in an economy

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What is Aggregate Demand?

Aggregate demand refers to the total demand for finished goods and services in an economy. Finished products are goods and services that have been fully manufactured – not including intermediate goods that are used as inputs in the production process.

Aggregate Demand - Image of the words aggregate demand and related concepts

Aggregate demand also refers to the demand for the country’s gross domestic product (GDP) and the measure of demand for goods and services at all price levels. A price level is the hypothetical overall price of goods and services in the economy. It is determined using the Consumer Price Index, which is a measure of the weighted price of a basket of typically purchased goods and services in the economy.

Aggregate Demand – Components

An economy’s aggregate demand is the sum of all individual demand curves from different sectors of the economy. It is typically the sum of four components:

Aggregate Demand – Formula

1. Government Spending (G)

Government spending (G) is the total amount of expenditure by the government on infrastructure, investments, defense and military equipment, public sector facilities, healthcare services, and government employees. It excludes the spending on transfer payments, such as pension plans, subsidies, and aid transfers to other countries that are in need.

2. Consumption Spending (C)

Consumption spending (C) is the largest component of an economy’s aggregate demand, and it refers to the total spending of individuals and households on goods and services in the economy. Consumption spending depends on several factors, such as disposable income, per capita income, debt, consumer expectations of future economic conditions, and interest rates.

An important point to note is that consumption spending does not include spending on residential structures, which is accounted for in the investment spending component.

3. Investment Spending (I)

Investment spending (I) is the total expenditure on new capital goods and services such as machinery, equipment, changes in inventories, investments in nonresidential structures, and residential structures. Investment spending depends on factors such as interest rates (since they determine the cost of borrowing), future expectations regarding the economy, and government incentives (such as tax benefits or subsidies for investing in renewable energy).

4. Net Exports (X–M)

Exports are products that are produced by domestic producers and sold abroad, while imports are products that are manufactured abroad and imported for domestic purchase.

It is important to remember that aggregate demand is the total demand for domestically produced goods and services; therefore, exports are added to the aggregate demand, whereas imports are subtracted. The measure of exports minus imports is called Net Exports, an important determinant of aggregate demand.

Shifts in Aggregate Demand

The aggregate demand curve plots the demand for domestically produced goods and services at all price levels. Real GDP measures the value of gross domestic product adjusted for inflation and provides a more accurate picture of changes in domestic demand than nominal GDP.

The AD curve is downward sloping since higher price levels correspond to lower demand for goods and services, which is in accordance with the Law of Demand.

Aggregate Demand Curve - Price Level vs Real GDP

Here are some of the reasons behind the downward slope of the AD curve:

1. Pigou’s Wealth Effect

Pigou’s Wealth Effect states that consumers are wealthier at lower price levels (assuming that wages are constant). Disposable income is higher at lower price levels and allows consumers to spend more on goods and services, increasing the demand for output.

2. Exchange Rate Effect

When the value of a country’s currency drops against other currencies, domestic goods become relatively cheaper to foreigners, and imports become more expensive. Therefore, at lower price levels, when domestic goods are cheaper compared to imported goods, the demand for exports is higher, and it leads to an increase in aggregate demand.

Factors that Cause Shifts in Aggregate Demand

An increase in any of the components of aggregate demand – consumption spending, investment spending, government spending, and net exports (X-M) – shifts the aggregate demand curve to the right, and a fall in any of these components shifts it to the left.

A shift from AD to AD1 reflects an increase in aggregate demand. A shift from AD to AD2 reflects a decrease. This can be the result of a change in any factors that influence the components of aggregate demand, including consumer confidence, investor confidence, tax policies, government spending on infrastructure, interest rates, and more.

Additional Resources

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