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How to Understand Aggregate Demand in Economics

Written by MasterClass

Last updated: Oct 2, 2020 • 5 min read

Economists look to a number of microeconomic and macroeconomic factors when attempting to gauge the health of the economy. One of the most important metrics they consider is the overall demand for the goods and services produced. This is referred to as aggregate demand.

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What Is Aggregate Demand?

Aggregate demand is, simply, the combined demand for all goods and services in an economy over a given period of time. Aggregate demand encompasses all spending on consumer goods, capital goods, imports, exports, and government spending programs.

How to Calculate Aggregate Demand

Aggregate demand is calculated by adding the amount of consumer spending, government and private investment spending, and the net of imports and exports. It is represented with the following equation: AD = C + I + G + Nx.

The components of aggregate demand are as follows:

  • C = consumer spending on goods and services
  • I = business/corporate spending and private investment on non-final goods
  • G = government spending on social services and public goods
  • Nx = net exports

What Is the Aggregate Demand Curve?

The aggregate demand curve (or AD curve) displays total spending on domestic goods and services at all price levels. The aggregate demand for goods and services runs along the horizontal axis, while the overall price level of those goods and services is displayed on the vertical axis.

The aggregate demand curve features a downward slope that moves from left to right, indicating that a higher price level results in a decrease in total spending. The curve can shift as a result of variations in the money supply or tax rates.

The aggregate demand curve can also be understood via its relationship with aggregate supply. Aggregate supply represents the total quantity of goods and services produced—in other words, the real GDP. The aggregate supply curve (known also as the short run aggregate supply curve) slopes upward, demonstrating the positive relationship between real GDP and price level.

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How Price Levels Affect Aggregate Demand

Increases in price level tend to lead to lower spending and a reduction in aggregate demand. Here are three reasons why:

  • Wealth effect: With an increase price levels comes a decrease in the buying power of savings. Since an increase in price levels reduces consumer wealth, consumption spending will decrease accordingly.
  • Interest rate effect: An increase in price levels boosts demand for money, and therefore credit. This forces interest rates higher, which consequently diminishes borrowing by businesses for the purposes of investment. In turn, this decreases borrowing by households for items like cars and homes, thereby reducing spending. The Federal Reserve can attempt to increase overall spending (aka aggregate demand) by lowering interest rates.
  • Foreign price effect: When US prices rise while other countries’ remain the same, US goods become more expensive vis-à-vis the rest of the world. This increases the price of US exports and therefore decreases their quantity. Meanwhile, international imports will be cheaper and their quantity will increase. For this reason, an increase in domestic price level compared to that of other countries results in a decline of net export expenditures.

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The 5 Factors That Affect Aggregate Demand

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There are a number of critical economic factors that can affect an economy’s aggregate demand. These include:

  1. Economic conditions: Domestic and international economic conditions can have an impact on aggregate demand. The 2008 financial crisis and the subsequent recession resulted in an unprecedented amount of people defaulting on their mortgage loans. This caused banks to post historic financial losses and resulted in a decrease in lending. Business investment and spending then diminished, leading to fewer sales, less capital investment, and, eventually, widespread layoffs. As economic growth stagnated and the unemployment rate rose, the lack of consumer confidence led to less personal spending—thus decreasing the aggregate demand.
  2. Inflation: If consumers believe that inflation is going to increase or that prices will rise, they are more likely to make purchases in the short term, which results in rising aggregate demand. The opposite is also true—if consumers think that prices are on the verge of falling, aggregate demand will likely sink.
  3. Interest rates: Consumers and businesses are both affected by fluctuations in interest rates. Higher interest rates increase the borrowing cost for companies and consumers alike, meaning that spending is likely to grow at a slower rate or decline. Lower interest rates, on the other hand, lower the cost of borrowing and thus boost spending.
  4. Wealth and income: Aggregate demand usually increases alongside the increase in household wealth and vice versa. But an increase in savings can actually have the opposite effect. When personal savings among consumers increases, it tends to lead to less demand for goods. This usually occurs during recessions. Conversely, when consumers are feeling positive and optimistic about the economy, their savings tend to decline because they are spending more of their disposable income.
  5. Currency exchange rate: As the United States dollar value falls, foreign goods will increase in price while domestic goods become cheaper for foreign markets, thus increasing aggregate demand. The opposite is also true—if the US dollar falls, foreign goods become less expensive as domestic goods increase in cost, resulting in a decrease in aggregate demand.

What Aggregate Demand Doesn’t Explain

Though aggregate demand can gauge the general strength of corporations and individual participants an economy, it does not account for other economic metrics like standard of living. The equation for aggregate demand also treats all consumer preferences and demands as uniform and constant. Any number of factors, such as the overall number and shifting tastes of consumers, can shift the demand curve. This can result in inaccurate assumptions when adding aggregate demand inputs, leading to difficulty when attempting to determine which factors actually influence demand.

What Is Aggregate Demand’s Relationship to GDP?

Over an extended period of time, the aggregate demand is equivalent to the gross domestic product (GDP), since both metrics are determined using the same basic calculation. Aggregate demand represents the public’s appetite for goods generated in an economy, while GDP refers to the total amount of those goods and services produced. Therefore, GDP and aggregate demand increase or decrease in unison.

What Is the Relationship Between Aggregate Demand and Growth?

Editors Pick

Economists often argue over a fundamental question: Does increased demand lead to economic growth, or does economic growth cause increased demand?

In the 1930s, British economist John Maynard Keynes advanced a theory that total demand drives supply. Since then, Keynesian economists have argued that promoting aggregate demand will increase future output. They believe that total spending determines all economic outcomes, from production to employment. To put it simply, Keynesians argue that producers observe increased levels of spending as a signal to increase production. Other economists and fiscal policy theorists, such as those from the Austrian School, argue that an increase in total output causes a rise in consumption—not vice versa. Learn more about Keynesian economcis in our article here.

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Learning to think like an economist takes time and practice. For Nobel Prize-winner Paul Krugman, economics is not a set of answers—it’s a way of understanding the world. In Paul Krugman’s MasterClass on economics and society, he talks about the principles that shape political and social issues, including access to health care, the tax debate, globalization, and political polarization.

Want to learn more about economics? The MasterClass Annual Membership provides exclusive video lessons from master economists and strategists, like Paul Krugman.

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