24.3: Aggregate Demand

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Introducing Aggregate Demand

Aggregate demand (AD) is defined as the total demand for final goods and services in a given economy at a specific time.

learning objectives

Define Aggregate Demand

Aggregate demand (AD) is defined as the total demand for final goods and services in a given economy at a specific time. Unlike other illustrations of demand, it is inclusive of all amounts of the product or service purchased at any possible price level. Simply put, AD is the sum of all demand in an economy. It is often called the effective demand or aggregate expenditure (AE), and is the demand of all gross domestic product (GDP).

Demand Sources

Consumption (C): This is the simplest and largest component of aggregate demand (usually 40-60% of all demand), and is often what is intuitively thought of as demand. Consumption is just the amount of consumer spending executed in an economy. Taxes play a role in this exchange as well (i.e. sales tax).
Investment (I): Investment is a relatively large portion of demand as well, and is referred to as Gross Domestic Fixed Capital Formation. This is the money spent by firms on capital investment (new machinery, factories, stocks, etc.). Investment equates to about 10% of GDP in most economies.
Government Spending (G): This is referred to as General Government Final Consumption, and is the expenditure by the government. This can include welfare, social services, education, military, etc. Fiscal policy is the way in which governments can alter this spending to drive economic change.
Net Export (NX): This can be put simply as the sale of goods to foreign countries subtracted by the purchase of goods from other countries (X-M). Trade surpluses and deficits can occur based on whether or not exports or imports are higher.

In summary, the calculation of aggregate demand can be represented as follows: \(\mathrm{AD = C + I + G + (X-M)}\). The full sum of all demand in an economy takes into account each of these factors in a quantitative way. This curve is illustrated in the figure.

Aggregate Demand and Supply: This graph demonstrates the basic relationship between aggregate demand and aggregate supply. The aggregate demand curve is derived via the consumption, investment, government spending, and net export.

The Role of Debt

Many societies have increasingly adopted debt and credit as an integral part of their economic system. This has justified the incorporation of debt (also called the credit impulse) into the larger framework of aggregate demand. From a quantitative perspective this is simply expressed as: Spending = Income + Net Increase in Debt. Spending capital prior to the receipt of capital is an important consideration at both the consumer level and the government level (deficit spending).

The Aggregation Problem

There are some limitations to the aggregation perspective, generally summarized as the aggregation problem. The difficulty arises in treating all consumer preferences (and thus their respective demands) as homogeneous and continuous. As the numbers of consumers, the tastes of consumers and the distribution levels of incomes will alter, so too will the demand curve. This can create inaccurate assumptions in AD inputs. Simply, there is some loss of accuracy in combining such a diverse array of economic inputs.

The Slope of the Aggregate Demand Curve

Due to Pigou’s Wealth Effect, the Keynes’ Interest Rate Effect, and the Mundell-Fleming Exchange Rate Effect, the AD curve slopes downward.

learning objectives

Explain the factors that influence the slope of the aggregate demand curve

Aggregate demand (AD) is the total demand for all goods within a given market at a given time, or the summation of demand curves within a system. Understanding the basic graphical representation of this curve is useful in grasping the implications of AD on an economic system, as well as the distinct effects which drive it. As a result of Keynes’ interest rate effect, Pigou’s wealth effect, and the Mundell-Fleming exchange rate effect, the AD curve is downward sloping.

Keynes’ Interest Rate Effect

The critical point from Keynes’s perspective on the slope of the aggregate demand curve is that interest rates affect expenditures more than they affect savings. If prices fall, a given amount of money will increase in value. This will drive up interest rates and investments. It is important to note that insufficient demand in a market will not go on forever.

In understanding this fully, it is useful to look at an IS-LM graph (see ). There are only two times when the Keynes observation on the interest rate effect will be inaccurate, and that is if the IS (investment savings) curve were to be vertical or if the LM ( liquidity preference money supply) curve were to be horizontal. This makes sense if you think about it, it would basically equate to a liquidity trap. A vertical IS curve or a horizontal LM curve would essentially negate the way in which interest rates could affect aggregate demand.

IS-LM Model: The IS-LM model takes investments and savings and compares that to liquidity and the overall money supply. It is highly useful in understanding macroeconomics from a Keynesian perspective. Interest rates (i) are on the vertical axis, and output (y) is on the horizontal axis.

Pigou’s Wealth Effect

In the context of the above discussion on Keynes, Pigou’s Wealth Effect underlines the fact that liquidity traps are not sustainable. The simplest way to explain the Wealth Effect is that an increase in spending will denote an increase in wealth. In many ways, what Pigou is putting forward is the idea that downwards spiral on the IS-LM model, as predicted by Keynes due to deflation, will be counterbalanced by an increase in real wages and thus an increase in expenditure. In other words, a decrease in employment and prices will eventually see higher purchasing power and an increase in spending, creating wealth.

Mundell-Fleming Exchange Rate Effect

Perhaps the most complex of the three inputs underlined in deriving aggregate demand is the Mundell-Fleming Exchange Rate Effect. Just like the previous two, this builds off of the IS-LM model in a way that discusses it in the context of an open economy (as opposed to a closed system). It essentially takes into account a new factor (in addition to interest rates and outputs, as the traditional IS-LM model incorporates). This new factor is the exchange rates, as the name implies. Robert Mundell and Marcus Fleming noted that incorporating the nominal exchange rate into the mix makes it impossible to maintain free capital movement, a fixed exchange rate and independent monetary policy. This is sometimes referred to as the ‘impossible trinity,’ implying that trade-offs must be made. This concept is illustrated fairly well in this figure, where ‘FE’ is fixed expenditure.

Mundell-Fleming Fixed Exchange Rate Illustration: An increase in government spending forces the monetary authority to supply the market with local currency to keep the exchange rate unchanged. Shown here is the case of perfect capital mobility, in which the BoP curve (or, as denoted here, the FE curve) is horizontal.

Conclusion

While these varying effects make the concept of aggregate demand slopes seem somewhat complicated, the most important thing to keep in mind is that people will be demanding more goods when they are cheaper. The analysis of interest rates displayed above, through the wealth effect in particular, offsets the negative spiral that could occur as a result of deflation and decreased employment. These effects also play a crucial role in understanding the way in which the larger and more complex environment, including investments and fiscal and monetary policy, will retain this downwards slope.

Reasons for and Consequences of Shifts in the Aggregate Demand Curve

An increase in any of the four inputs into AD will result in higher real output or an increase in prices.

learning objectives

Describe exogenous events that can shift the aggregate demand curve

Aggregate demand (AD) is the summation of all demand within a given economy at a given time.

Inputs

There are four inputs to consider in calculating AD (and deriving the graphical curve which represents it): consumption (C), investment (I), government spending (G), and net exports (NX, which is exports (X) – imports (I)). Changes in these inputs will have some influence on the AD curve. For example, an increase in total expenditures will result in a shift rightwards, while a decrease in expenditure will result in a shift to the left.

Aggregate Demand Curves

Two specific AD representations are useful to consider:

Keynesian Cross: The Keynesian Cross is a simple illustration of the relationship between aggregate demand and desired total spending (linear at 45 degrees). The intersecting AD line will generally have an upwards slope, under the assumption that increased national output should result in increased disposable income.
Aggregate Demand/Aggregate Supply Model (\(\mathrm{\frac{AD}{AS}}\)):The x-axis represents the overall output, while the y-axis represents the price level. The aggregate quantity demanded (\(\mathrm{Y = C + I + G + NX}\)) is calculated at every given aggregate average price level.

Exogenous Effects

There are a variety of direct and indirect consequences to AD shifts. For the purpose of this discussion, the key consequences to keep in mind are changes in output and price. Below are some of the driving forces that will shift aggregate demand to the right:

An exogenous increase in consumer spending;
An exogenous increase in investment spending on physical capital;
An exogenous increase in intended inventory investment;
An exogenous increase in government spending on goods and services;
An exogenous increase in transfer payments from the government to the people;
An exogenous decrease in taxes levied;
An exogenous increase in purchases of the country’s exports by people in other countries; and
An exogenous decrease in imports from other countries.

Short-term Implications

As noted above, any increase in the overall AD will result in an outwards (right-ward) shift of the AD curve. (Conversely, a decrease in aggregate demand will cause a leftward shift of the AD curve. ) This means that an increase in any of the four inputs to AD will result in a higher quantity of real output or an increase in prices across the board (this is also known as inflation). However, different levels of economic activity will result in different combinations of output and price increases.

is useful for understanding the distribution between price increases and output increases that will result in a given economy when AD increases. To put simply, the lower the utilization of available resources in a system, the more an increase in AD will result in higher output and thus higher employment and GDP growth. However, as the system evolves and aligns itself closer to the highest potential output (optimal utilization of resources or Y*), scarcity will naturally cause the prices to increase more than the overall output in a system. This is somewhat intuitive economically when scarcity and utilization are taken into account. The more difficult it is to generate a supply increase the more likely a shift in AD will drive up prices.

368px-as-2b-ad-graph.svg_.png 　

Aggregate Supply/Aggregate Demand: This graph illustrates the relationship between price and output within a given economic system in the context of aggregate demand and supply.

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