Aggregate demand definition

What is aggregate demand?

Aggregate demand is the total demand for final goods and services in a market, sector or economy. Aggregate demand shows how current price levels relate to a nation’s real gross domestic product (GDP).

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Real GDP shows the value of an economy’s output, adjusted for any changes in inflation, interest rates or other factors which could affect price levels. By tracking the demand for goods and services, aggregate demand can help to show what quantity of goods and services will be purchased at various price levels.

As a result, aggregate demand is also an indicator of whether spending in a given economy is high or low. High spending could mean that people are not currently incentivised to save, perhaps because interest rates are low, or inflation is expected to rise. Low spending could mean that people are currently saving more, perhaps because interest rates are high, or inflation is under control.

Aggregate demand curve explained

The aggregate demand curve represents the total quantity of goods and services which are currently in demand at different price levels. It is usually assumed that the curve will slope downward because of the law of demand, which states that the demand for a good will decrease alongside an increase in price.

You could draw a line from the price axis to the aggregate demand curve and see how the price level corresponds to the real GDP. This is demonstrated in the below graphic.

How to calculate aggregate demand

The calculation for aggregate demand is as follows:

AD = C + I + G + E-M

Where:

  • AD = aggregate demand
  • C = consumption
  • I = investment
  • G = government spending
  • E-M = net exports

Components of aggregate demand

The first component is consumption (C). This can be quantified as disposable income, which is the money that a consumer has available to them to spend purchasing goods and services.

Next is investment (I), which signifies investment by firms or businesses, not by consumer households.

The third component is government spending (G), and this spending includes pensions, unemployment benefits and infrastructure projects – such as schools, hospitals and roads.

The final part of the equation is net exports (E-M), which is calculated by the total exports (E) minus the total imports (M).

Once all of these components have been worked out, they can be added up to get a total aggregate demand figure for a given period.

What are the causes of AD shocks?

Aggregate demand ‘shocks’ are sudden increases or decreases in aggregate demand. They can occur for a number of reasons, which are all to do with the amount of money available to the public for spending.

For example, if inflation rates are predicted to rise, it is likely that many consumers will buy products in the present to prevent them from being overcharged in the future. This will increase spending, which will push aggregate demand up in a positive shock.

Equally, if income and wealth in a sector or economy is increasing, then consumers will have more money to spend on goods and services which will cause the aggregate demand in that sector to increase.

On the other hand, aggregate demand can fall dramatically – a negative shock – if there are unexpected financial crises in the economy. For example, the 2008 financial crises caused consumer wealth and spending to decrease significantly, which meant that there was less money available to spend on goods and services. This caused aggregate demand in many sectors – and the global economy as a whole – to fall.

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