Aggregate Demand: Formula, Components, and Limitations

What Is Aggregate Demand?

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Aggregate demand measures the total demand for all finished goods and services produced in an economy. Aggregate demand is the total amount of money exchanged for those goods and services at a specific price and time.

KEY TAKEAWAYS

• Aggregate demand measures the total market for all finished goods and services produced in an economy.
• Aggregate demand is the total amount of money spent on those goods and services at a specific price and time.
• Aggregate demand consists of all consumer goods, capital goods (factories and equipment), exports, imports, and government spending.

Understanding Aggregate Demand

Aggregate demand is a macroeconomic term representing the total demand for goods and services at any given price level in a given period. Aggregating demand over a long time equals gross domestic product (GDP) because the two metrics are calculated similarly. 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 the 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 considered equal if they trade at the same market value.

Drawbacks of Aggregate Demand

While aggregate demand helps determine the overall strength of consumers and businesses in an economy, it does have limits. Since market values measure aggregate demand, it only represents total output at a given price level. It does not necessarily mean a society’s quality of life or standard of living.

Also, aggregate demand measures various economic transactions between millions of individuals for multiple purposes. As a result, it can become challenging to determine the causality of the request and run a regression analysis, determining how many variables or factors influence the direction and to what extent.

Aggregate Demand Curve

If you were to represent aggregate demand graphically, the aggregate amount of goods and services demanded would be placed on the horizontal X-axis, and the overall price level of the entire basket of goods and services would be represented on the vertical Y-axis.

Like most typical demand curves, the aggregate demand curve slopes downward from left to right. Demand increases or decreases along the curve as prices for goods and services increase or decrease. Also, the angle can shift due to changes in the money supply, or increases and decreases in tax rates.

Components of Aggregate Demand

Aggregate demand is the sum of the demand curves for different sectors of the economy. This is usually divided into four components:

Consumer Spending

Consumer spending represents the demand by individuals and households within the economy. While there are several factors in determining consumer demand, the most important are consumer income and taxation.

Government Spending

Government spending represents the demand produced by government programs, such as infrastructure spending and public goods. This does not include Medicare or social security services because these programs transfer demand from one group to another.

Net Exports

Net exports represent the demand for foreign goods, as well as the foreign demand for domestic goods. It is calculated by subtracting a country’s exports from the total value of all imports.

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:

Aggregate Demand = C+I+G+Nx
Where:
C = Consumer spending on goods and services
I = Private investment and corporate spending on non-final capital goods (factories, equipment, etc.)
G = Government expenditure on public goods and social services (infrastructure, Medicare, etc.)
Nx=Net exports (exports minus imports)

The Bureau of Economic Analysis also uses the aggregate demand formula above to measure GDP in the U.S.

Factors That Influence Aggregate Demand

A variety of economic factors can affect the aggregate demand in an economy. Key ones include:

• 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 can borrow at lower speeds, leading to increased capital spending. Conversely, higher interest rates increase the cost of borrowing for consumers and companies. As a result, spending tends to decline or grow slower, depending on the extent of the rate increase.
• Income and Wealth: As household wealth increases, aggregate demand increases. 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 feel good about the economy, they tend to spend more, leading to a decline in savings.
• Inflation Expectations: Consumers who feel that inflation will increase or prices will rise tend to make purchases now, which leads to rising aggregate demand. However, if consumers believe prices will fall in the future, aggregate demand also tends to decrease.
• Currency Exchange Rates: 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 costly) 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 financial crisis of 2007-08, sparked by massive amounts of mortgage loan defaults and the ensuing Great Recession, offers an excellent example of a decline in aggregate demand due to economic conditions.

The crises had a severe impact on banks and financial institutions. As a result, they reported widespread financial losses, leading to a contraction in lending, as shown in the graph on the left below. With less borrowing in the economy, business spending and investment declined. The chart below shows a significant drop in spending on physical structures such as factories, equipment, and software throughout 2008 and 2009. (Data is based on the Federal Reserve Monetary Policy Report to Congress of 2011.)

With less access to capital and fewer sales, businesses began to lay off workers. The graph on the left shows the unemployment spike during the recession. Simultaneously, GDP growth also contracted in 2008 and 2009, which means that the total production in the economy contracted during that period.

A poor-performing economy and rising unemployment resulted in 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 following years led to less aggregate demand by consumers and businesses.

Aggregate Demand Controversy

Aggregate demand declined in 2008 and 2009. 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 to an increase 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 increasing aggregate demand creates economic growth. Since GDP and aggregate demand share the same calculation, it only indicates 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 of major debates in economic theory for many years.

Historical Debate

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. That social needs are essentially limitless; a theory referred to as Say’s Law of Markets.

Say’s law, the basis of supply-side economics, ruled until the 1930s and the advent of the theories of British economist John Maynard Keynes. Keynes argued that demand drives supply and places total order in the driver’s seat. Keynesian macroeconomists have since believed that stimulating aggregate demand will increase actual future output. According to their demand-side theory, the total output level in the economy is driven by the need for goods and services and propelled by money spent on those goods and services. In other words, producers look to rising spending levels as an indication to increase production.

Keynes considered unemployment 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 maldistribution of wealth, higher prices, or both.

As a demand-side economist, Keynes further argued that individuals could end up damaging production by limiting current expenditures—by hoarding money, for example. Other economists argue 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 because of a lack of spending.

What Factors Affect Aggregate Demand?

A few critical economic factors can impact aggregate demand. Rising or falling interest rates will affect decisions made by consumers and businesses. Rising household wealth increases aggregate demand, while a decline usually leads to lower aggregate demand. Consumers’ expectations of future inflation will also positively correlate with aggregate demand. Finally, a decrease (or increase) in the value of the domestic currency will make foreign goods costlier (or cheaper). In contrast, goods manufactured in the domestic country will become more affordable (or more expensive), leading to an increase (or decrease) in aggregate demand. 

What Are Some Limitations of Aggregate Demand?

While aggregate demand helps determine the overall strength of consumers and businesses in an economy, it does pose some limitations. Since market values measure aggregate demand, it only represents total output at a given price level and does not necessarily represent quality or standard of living. Also, aggregate demand measures different economic transactions between millions of individuals for other purposes. As a result, it can become challenging to determine the causes of the need for analytical purposes.

What’s the Relationship Between GDP and Aggregate Demand?

GDP (gross domestic product) measures the size of an economy based on the monetary value of all finished goods and services made within a country during a specified period. As such, GDP is the aggregate supply. Aggregate demand represents the total demand for these goods and services at any given price level during the specified period. Aggregate demand eventually equals gross domestic product (GDP) because the two metrics are calculated similarly. As a result, aggregate demand and GDP increase or decrease together.

The Bottom Line

Aggregate demand is a concept of macroeconomics that represents the total demand within an economy for all kinds of goods and services at a specific price point. In the long term, aggregate demand is indistinguishable from GDP. However, aggregate demand is not a perfect metric and is the subject of debate among economists.