Aggregate Demand – Formula and Drawbacks

What Is Aggregate Demand?

Aggregate demand (AD) is the total expenditures on consumer goods and services in the economy. It refers to the total amount of money exchanged for goods and services at a specific price level, excluding imports and exports. Aggregate demand is often referred to as total demand.

Understanding Aggregate Demand

Aggregate demand is a macroeconomic term representing the total demand for goods and services in the economy at a given price level. The aggregate demand curve shows the relationship between national income and the general level of prices, holding all else equal. GDP is the standard by which an economy is measured. While GDP measures the total value of goods and services produced in a country, aggregate demand accounts for the demand or desire for those goods and services. Because the calculation methods of aggregate demand and GDP are equal, they move up and down together. When aggregate demand increases, so do GDP.

Aggregate demand is an economic term for total demand in the economy at a given price level. Short-run aggregate demand, which only considers fixed prices over the short-term, pays no attention to inflation or deflation by assuming that all firms can adjust their prices up if they are experiencing greater demand. Meanwhile, long-run aggregate supply assumes that all prices are flexible by considering changes in productivity of labor and capital as well as expected future price increases based on inflation.

Aggregate demand consists of all consumer, capital goods, exports, imports, and government spending programs. These elements are held equal in an economy when they trade at the same market value.

Drawbacks of Aggregate Demand

Aggregate demand is a useful indicator of the overall economy, but it does have drawbacks. First, because aggregate demand is based on prices, it does not represent the quality of life or standard of living in a society.

This problem can be fixed by looking at the real gross domestic product (GDP), an economic indicator that measures how much the total output of goods and services has increased. Real GDP takes into account changes in price as well as changes in production. The other drawback of aggregate demand is that it only considers the total output at a given price level; it does not necessarily ensure that everyone in the society will enjoy the improved living standard.

It is difficult to use aggregate demand to generalize causality in regression analysis because it can be measured in many different ways and comes from many different sources.

Aggregate Demand Curve

The aggregate demand curve, like all other demand curves, slopes downward from left to right. The overall quantity demanded will be represented on the horizontal axis, while the price level is represented on the vertical axis; hence, the demand curve will represent the relationship between the overall price level and the overall purchasing power of customers.

The Aggregate Demand Curve illustrates the relationship between the overall price level and the total demand for goods and services in the economy. The aggregate demand curve shows that as the overall price level (or inflation rate) rises, consumers will demand fewer goods and services, other things equal.

A rise in the aggregate demand for goods and services, which increases the overall price level, can be caused by an increase in any of several components of aggregate demand: consumption spending (C), investment (I), government purchases (G), or net exports (NX). The Aggregate Demand Curve helps us see how changes in each of these components affect the entire economy.

Calculating Aggregate Demand

The equation for aggregate demand is AD = C + I + G + (X-M). 

The formula tells us that the total demand for goods and services in an economy at any given time is equal to the sum of consumer spending (C), business investment (I), government purchases (G), and net exports (X-M).

The sum of consumer spending, private investment, government spending, and net exports makes up all the spending in the economy. The equation for aggregate demand, then, is just a way of stating that total spending equals total income. Or, more broadly, that aggregate supply equals aggregate demand.

Factors That Influence Aggregate Demand

Interest Rates: Interest rates have a significant effect on aggregate demand. When interest rates rise, the cost of borrowing money increases, which can lead to slower growth in incomes or spending. Interest rates have a direct effect on aggregate demand by influencing company capital expenditures and consumer purchases. The higher the interest rate, the more it will cost a company to borrow for new projects. In addition, when interest rates rise, consumers will buy less durable goods because they will want to save money before buying durable goods.

Income and Wealth: Personal income and wealth act to affect aggregate demand. As personal incomes increase, consumers will tend to spend more, thus leading to higher aggregate demand. Conversely, if personal incomes decline, consumers will spend less, which leads to lower aggregate demand. As household savings increase, consumers will spend less on goods and thus leads to lower aggregate demand.

Inflation Expectations: Economic conditions, such as inflation and unemployment, can affect aggregate demand. If many consumers expect inflation to rise, they’ll buy goods now before prices go up. But if they expect inflation to fall, they’ll postpone their buying.

Currency Exchange Rates: The value of the U.S. dollar relative to other currencies will either create or stifle aggregate demand. For example, if the value is low, the demand for U.S.-made goods in foreign markets will increase, while foreign-made goods purchased in the U.S. will decrease.

Economic Conditions and Aggregate Demand

As economic conditions impact aggregate demand, fluctuating financial and business conditions can influence macroeconomic factors. For example, the recession triggered by the bursting of the U.S. housing bubble in 2008 is a prime example of a decline in aggregate demand due to economic conditions.

The global economic crisis and its impacts on banks and other financial institutions resulted in widespread financial losses, causing a contraction in lending and reducing business spending and investment.

Businesses were going through a difficult economy due to a lack of physical and financial capital, which caused them to lay off workers. There was a steep decline in GDP during the recession, with a contraction of total production in the economy during that period.

Economic downturns such as the Great Recession (and 2007-2009 financial crisis) occurred due to a poor performing economy and unemployment rise when aggregate demand for goods and services outpaced aggregate supply. Personal savings increased during this time when consumers held onto cash due to uncertainty in the future.

Aggregate Demand Controversy

After the recession of 2008 and 2009, most economists agree that aggregate demand declined. However, they disagree about whether aggregate demand is the cause of lower growth or GDP is the cause of lower aggregate demand. The debate over the true cause of the great recession has been ongoing since it began in 2008.

When aggregate demand increases, so do the size of the GDP. However, it would be difficult to ascertain whether the increase in aggregate demand causes an increase in GDP or correlated with the increase in GDP. The correlation itself is evidence that there are external factors involved.

The debate about the relationship between aggregate demand and economic growth has been ongoing for many years.

What’s the Relationship Between GDP and Aggregate Demand?

GDP is essentially the sum of all final goods and services produced in an economy over time. It’s also known as the aggregate supply.

Aggregate demand measures total spending in the economy during a specified period. As aggregate demand changes, so do GDP. GDP is essentially the sum of all final goods and services produced in an economy over time. Increase aggregate demand over time, and the available goods and services grow.