Aggregate Demand

What is Aggregate Demand?

Aggregate demand is an economic measurement of the total amount of demand for all finished goods and services produced in an economy. Aggregate demand is expressed as the total amount of money exchanged for those goods and services at a specific price level and point in time.

Aggregate demand (AD) represents the amount of total demand for an economy’s finished goods and services during a specified period at a given price level.

Aggregate demand is an economic measurement of the sum of all final goods and services produced in an economy, expressed as the total amount of money exchanged for those goods and services. Since aggregate demand is measured by market values, it only represents total output at a given price level and does not necessarily represent quality or standard of living.

In macroeconomics, aggregate demand (AD)… is the total demand for final goods and services in an economy at a given time. It specifies the amounts of goods and services that will be purchased at all possible price levels. This is the demand for the gross domestic product of a country. It is often called effective demand, though at other times this term is distinguished.

The aggregate demand curve is plotted with real output on the horizontal axis and the price level on the vertical axis. It is downward sloping as a result of three distinct effects: Pigou’s wealth effect, Keynes’ interest rate effect and the Mundell-Fleming exchange-rate effect. The Pigou effect states that a higher price level implies lower real wealth and therefore lower consumption spending, giving a lower quantity of goods demanded in the aggregate. The Keynes effect states that a higher price level implies a lower real money supply and therefore higher interest rates resulting from financial market equilibrium, in turn resulting in lower investment spending on new physical capital and hence a lower quantity of goods being demanded in the aggregate.

Understanding Aggregate Demand

Aggregate demand represents the total demand for goods and services at any given price level in a given period. Aggregate demand over the long-term equals gross domestic product (GDP) because the two metrics are calculated in the same way. GDP represents the total amount of goods and services produced in an economy while aggregate demand is the demand or desire for those goods. As a result of the same calculation methods, the aggregate demand and GDP increase or decrease together.

Technically speaking, aggregate demand only equals GDP in the long run after adjusting for the price level. This is because short-run aggregate demand measures total output for a single nominal price level whereby nominal is not adjusted for inflation. Other variations in calculations can occur depending on the methodologies used and the various components.

Aggregate demand consists of all consumer goods, capital goods (factories and equipment), exports, imports, and government spending programs. The variables are all considered equal as long as they trade at the same market value.

Calculating Aggregate Demand

The equation for aggregate demand adds the amount of consumer spending, private investment, government spending, and the net of exports and imports. The formula is shown as follows:

AD = C + I + G + (X-M)

The Components of Aggregate Demand (AD)

C: Consumers’ expenditure on goods and services: Also known as consumption, this includes demand for durables e.g. audio-visual equipment and vehicles & non-durable goods such as food and drinks which are “consumed” and must be re-purchased.

I: Capital Investment – This is spending on capital goods such as plant and equipment and new buildings to produce more consumer goods in the future. Investment includes spending on working capital such as stocks of finished and semi-finished goods.

Capital investment spending in the UK accounts for between 15-20% of GDP in any given year. Of this investment, 75% comes from private sector businesses such as Tesco, British Airways and British Petroleum and the remainder is spent by the government – for example building new schools or in improving rail or road networks. Investment has important effects on the supply-side as well as being an important component of AD.

A small part of investment spending is the change in the value of stocks. Producers may find either than demand is running higher than output (i.e. stocks will fall) or that demand is weaker than expected and below current output (in which case the value of stocks will rise.)

G: Government Spending – This is spending on state-provided goods and services including public goods and merit goods. Decisions on how much the government will spend each year are affected by developments in the economy and the political priorities of the government.

Government spending on goods and services is around 18-20% of GDP but this tends to understate the true size of the government sector in the economy. Firstly some spending is on investment and a sizeable amount goes on welfare state payments.

Transfer payments in the form of benefits (e.g. state pensions and the job-seekers allowance) are not included in current government spending because they are a transfer from one group (i.e. people paying income taxes) to another (i.e. pensioners drawing their state pension having retired, or families on low incomes).

X: Exports of goods and services – Exports sold overseas are an inflow of demand (an injection) into our circular flow of income and spending adding to aggregate demand.

M: Imports of goods and services. Imports are a withdrawal of demand (a leakage) from the circular flow of income and spending.

Net exports measure the value of exports minus the value of imports. When net exports are positive, there is a trade surplus (adding to AD); when net exports are negative, there is a trade deficit (reducing AD). The UK has been running a large trade deficit for several years now.