Aggregate demand

From Academic Kids

In economics, aggregate demand is the total demand for goods and services in the economy (Y) during a specific time period. It is often called effective demand. Put another way, it is the demand for the gross domestic product of a country (the total new production sold through the market). This demand consists of four major parts, which can be stated in either nominal or "real" terms:

  • personal consumption expenditures (C) or "consumption," demand by households and unattached individuals; its determination is described by the consumption function.
  • gross private domestic investment (I), demand by business firms and some individuals, for new factories, machinery, computer software, housing, other structures, and inventories.
  • gross government investment and consumption expenditures (G).
  • net exports (NX), i.e., net demand by the rest of the world for the country's output.

In Keynesian economics, not all of gross private domestic investment counts as part of aggregate demand. Much or most of the investment in inventories can be due to a short-fall in demand (unplanned inventory accumulation or "general over-production"). (Inventory accumulation would correspond to an excess supply of products; in the National Income and Product Accounts, it is treated as a purchase by its producer.) Thus, only the planned or intended or desired part of investment (Ip) is counted as part of aggregate demand.

In sum, for a single country at a given time, aggregate demand (D or AD) = C + Ip + G + NX.

Strictly speaking, it is questionable whether this aggregation is possible, as it is impossible to form such macrovariables from some microvariables: how do you add up litres of gasoline and toothbrushes? In the sense of nominal monetary values (prices) this is possible; but in the sense of real goods it is not. Therefore it might be argued that an "aggregate demand curve" does not even exist in an (income,spending)-space.


Two Concepts of the "Aggregate Demand Curve"

One's concept of the aggregate demand curve depends on whether one examines changes in demand as income changes or as prices change.

Keynesian Cross

Missing image

In the "Keynesian cross diagram," a desired total spending (or "aggregate demand") curve is often drawn as a rising level of D as total national output and income rise. This increase is due to the positive relationship between C and consumers' disposable income in the consumption function. It may also rise due to increases in investment (due to the accelerator effect), while this rise is reduced if imports and tax revenues rise with income. Equilibrium in this diagram occurs where total spending (D) equals the total amount of national income (which corresponds to total national output or production). Here, total demand equals total supply.

In the diagram, the equilibrium level of output, income, and demand is determined where this desired spending curve intersects the "Z curve," a line that represents the equality of total income and output. This is at point E, determining the equilibrium levels of output and income on the horizontal axis (where the arrow points).

The movement toward equilibrium is mostly via changes in inventories inducing changes in production and income. If current output exceeds the equilibrium, inventories accumulate, encouraging businesses to cut back on production, moving the economy toward equilibrium. Similarly, if the level of production is below the equilibrium, then inventories run down, encouraging an increase in production and thus a move toward equilibrium. This equilibration process occurs when the equilibrium is stable, i.e., when the D line is flatter than the Z line.

The equilibrium level of output determines the equilibrium level of employment in the model. (In a dynamic view, these are connected by Okun's Law.) There is no reason within the model why the equilibrium level of employment should correspond to full employment. Bringing in other considerations may imply this correspondence, though.

If any of the components of aggregate demand (C + Ip + G + NX) rises at each level of income, for example because business becomes more optimistic about future profitability, that shifts the entire D line upward. This raises equilibrium income and output. Similarly, if the elements of D fall, that shifts the line downward and lowers equilibrium output. (The Z line does not shift under the definition used here.)

Marshallian Cross

Sometimes, especially in textbooks, "aggregate demand" refers to an entire demand curve that looks like that in a typical Marshallian supply and demand diagram.

Missing image

Thus, that we could refer to an "aggregate quantity demanded" (Yd = C + Ip + G + NX in real or inflation-corrected terms) at any given aggregate average price level (such as the GDP deflator), P.

In these diagrams, typically the Yd rises as the average price level (P) falls, as with the AD line in the diagram. The main theoretical reason for this is that if the nominal money supply (Ms</s>) is constant, a falling P implies that the real money supply (Ms</s>/P)rises, encouraging lower interest rates and higher spending. This is often called the "Keynes effect."

Carefully using ideas from the theory of supply and demand, aggregate supply can help determine the extent to which increases in aggregate demand lead to increases in real output or instead to increases in prices (inflation). In the diagram, an increase in any of the components of AD (at any given P) shifts the AD curve to the right. This increases both the level of real production (Y) and the average price level (P).

But different levels of economic activity imply different mixtures of output and price increases. As shown, with very low levels of real gross domestic product and thus large amounts of unemployed resources, most economists of the Keynesian school suggest that most of the change would be in the form of output and employment increases. As the economy gets close to potential output (Y*), we would see more and more price increases rather than output increases as AD increases.

Beyond Y*, this gets more intense, so that price increases dominate. Worse, output levels greater than Y* cannot be sustained for long. The AS is a short-term relationship here. If the economy persists in operating above potential, the AS curve will shift to the left, making the increases in real output transitory.

At low levels of Y, the world is more complicated. First, most modern industrial economies experience few if any falls in prices. So the AS curve is unlikely to shift down or to the right. Second, when they do suffer price cuts (as in Japan), it can lead to disastrous deflation.

See Also


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