Championed by English economist John Maynard Keynes (1883-1946), aggregate demand theory asserts that the total demand within an economy helps to determine the level of output and growth.
If demand and consumption are lowered (for example, through wage cuts), overall economic activity will be reduced.
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.
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.
Aggregate Demand Curve
If you were to represent aggregate demand graphically, the aggregate amount of goods and services demanded is represented on the horizontal X-axis, and the overall price level of the entire basket of goods and services is represented on the vertical Y-axis.
The aggregate demand curve, like most typical demand curves, slopes downward from left to right. Demand increases or decreases along the curve as prices for goods and services either increase or decrease. Also, the curve can shift due to changes in the money supply, or increases and decreases in tax rates.
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 + Nx
- C = Consumer spending on goods and services
- I = Private investment and corporate spending on non-final capital goods (factories, equipment, etc.)
- G = Government spending on public goods and social services (infrastructure, Medicare, etc.)
- Nx = Net exports (exports minus imports)
The aggregate demand formula above is also used by the Bureau of Economic Analysis to measure GDP in the U.S.
Factors That Can Affect Aggregate Demand
The following are some of the key economic factors that can affect the aggregate demand in an economy.
Changes in Interest Rates
Whether interest rates are rising or falling will affect decisions made by consumers and businesses. Lower interest rates will lower the borrowing costs for big-ticket items such as appliances, vehicles, and homes. Also, companies will be able to borrow at lower rates, which tends to lead to capital spending increases.
Conversely, higher interest rates increase the cost of borrowing for consumers and companies. As a result, spending tends to decline or grow at a slower pace, depending on the extent of the increase in rates.
Income and Wealth
As household wealth increases, aggregate demand usually increases as well. Conversely, a decline in wealth usually leads to lower aggregate demand. Increases in personal savings will also lead to less demand for goods, which tends to occur during recessions. When consumers are feeling good about the economy, they tend to spend more leading to a decline in savings.
Changes in Inflation Expectations
Consumers who feel that inflation will increase or prices will rise, tend to make purchases now, which leads to rising aggregate demand. But if consumers believe prices will fall in the future, aggregate demand tends to fall as well.
Currency Exchange Rate Changes
If the value of the U.S. dollar falls (or rises), foreign goods will become more (or less expensive). Meanwhile, goods manufactured in the U.S. will become cheaper (or more expensive) for foreign markets. Aggregate demand will, therefore, increase (or decrease).
Economic Conditions and Aggregate Demand
Economic conditions can impact aggregate demand whether those conditions originated domestically or internationally. The mortgage crisis of 2008 is a good example of a decline in aggregate demand due to economic conditions.
The financial crisis in 2008 and the Great Recession that began in 2009 had a severe impact on banks due to massive amounts of mortgage loan defaults. As a result, banks reported widespread financial losses leading to a contraction in lending, as shown in the graph on the left below. All graphs and data were furnished by the Federal Reserve Monetary Policy Report to Congress of 2011.
With less lending in the economy, business spending and investment declined. From the graph on the right, we can see a significant drop in spending on physical structures such as factories as well as equipment and software throughout 2008 and 2009.
With businesses suffering from less access to capital and fewer sales, they began to layoff workers. The graph on the left shows the spike in unemployment that occurred during the recession. Simultaneously, GDP growth also contracted in 2008 and in 2009, which means that the total production in the economy contracted during that period.
The result of a poor performing economy and rising unemployment was a decline in personal consumption or consumer spending—highlighted in the graph on the left. Personal savings also surged as consumers held onto cash due to an uncertain future and instability in the banking system. We can see that the economic conditions that played out in 2008 and the years to follow lead to less aggregate demand by consumers and businesses.
Aggregate Demand Controversy
As we saw in the economy in 2008 and 2009, aggregate demand declined. However, there is much debate among economists as to whether aggregate demand slowed, leading to lower growth or GDP contracted, leading to less aggregate demand. Whether demand leads growth or vice versa is economists’ version of the age-old question of what came first—the chicken or the egg.
Boosting aggregate demand also boosts the size of the economy regarding measured GDP. However, this does not prove that an increase in aggregate demand creates economic growth. Since GDP and aggregate demand share the same calculation, it only echoes that they increase concurrently. The equation does not show which is the cause and which is the effect.
The relationship between growth and aggregate demand has been the subject major debates in economic theory for many years.
Early economic theories hypothesized that production is the source of demand. The 18th-century French classical liberal economist Jean-Baptiste Say stated that consumption is limited to productive capacity and that social demands are essentially limitless, a theory referred to as Say’s law.
Say’s law ruled until the 1930s, with the advent of the theories of British economist John Maynard Keynes. Keynes, by arguing that demand drives supply, placed total demand in the driver’s seat. Keynesian macroeconomists have since believed that stimulating aggregate demand will increase real future output. According to their demand-side theory, the total level of output in the economy is driven by the demand for goods and services and propelled by money spent on those goods and services. In other words, producers look to rising levels of spending as an indication to increase production.
Keynes considered unemployment to be a byproduct of insufficient aggregate demand because wage levels would not adjust downward fast enough to compensate for reduced spending. He believed the government could spend money and increase aggregate demand until idle economic resources, including laborers, were redeployed.
Other schools of thought, notably the Austrian School and real business cycle theorists, hearken back to Say. They stress consumption is only possible after production. This means an increase in output drives an increase in consumption, not the other way around. Any attempt to increase spending rather than sustainable production only causes maldistributions of wealth or higher prices, or both.
Keynes further argued that individuals could end up damaging production by limiting current expenditures—by hoarding money, for example. Other economists argue that hoarding can impact prices but does not necessarily change capital accumulation, production, or future output. In other words, the effect of an individual’s saving money—more capital available for business—does not disappear on account of a lack of spending.
Limitations of Aggregate Demand
Aggregate demand is helpful in determining the overall strength of consumers and businesses in an economy. 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.
Also, aggregate demand measures many different economic transactions between millions of individuals and for different purposes. As a result, it can become challenging when trying to determine the causality of demand and run a regression analysis, which is used to determine how many variables or factors influence demand and to what extent.
Aggregate demand theory has been overshadowed in recent years by supply-side economics.