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What’s it: Aggregate demand (AD) is the sum of demand for goods and services in the economy at a given price level and a certain period. In the open economy, it comprises demand from four macroeconomic sectors: households, businesses, governments, and foreign sectors.
Aggregate demand formula and components
To understand aggregate demand, let’s describe the components. We calculate this by summing the aggregate demand of the four macroeconomic sectors (household, business, government, and external):
- Aggregate demand = Consumption + Investment + Government expenditure + Net exports
Consumption
Consumption represents household spending on goods and services. The key determinant of this component is disposable income, sometimes also called after-tax income.
Higher disposable income increases both consumption and savings. How much a household saves and consumes of the additional money it receives depends on household habits. We measure this habit through indicators of marginal propensity to consume and marginal propensity to save.
Because disposable income also depends on taxes, we need to consider the effect of this variable in the analysis of household consumption. Reduced personal taxes give households more money to spend or save. Conversely, a tax increase reduces disposable income, hence consumption and savings.
Besides personal income, several factors also affect household consumption. Among them are wealth, consumer expectations, inflation, and interest rates. However, economists conclude that disposable income is the most dominant factor in explaining consumption. No income means no money for consumption and savings.
Investment
Investment expenditure is the purchase of goods and services by businesses. Purchases are usually for physical capital, which is essential for their production capacity. Investment decisions mainly depend on expected profits and funding costs.
Economists use real GDP as a proxy to explain the expected profit. The expected return of new investment is high when real GDP is expanding. And conversely, if real GDP falls (contraction), such investments are unprofitable. The reason is that, during a contraction, demand for goods and services is weak. Hence, it is unlikely that companies can sell additional output generated from new capital investment.
Funding costs also affect businesses’ investments. To measure the cost, economists use real interest rates rather than nominal interest rates. The real interest rate is the inflation-adjusted nominal interest rate.
Lower real interest rates lead to lower investment costs. And, the opposite effect applies when real interest rates are higher.
Government spending
Government expenditures are considered an exogenous variable. This is because economic variables such as economic growth, currency exchange rates, and interest rates do not affect spending decisions.
Net exports
Net exports equal exports minus imports. Exports are foreign demand for domestic output, and imports represent domestic demand for foreigners’ output. This component is determined by relative income and prices between the domestic economy and the world.
In aggregate, real GDP growth represents a country’s income, and the inflation rate reflects a country’s general prices. Also, since international trade involves different currencies, the exchange rate affects the price level. Hence, in assessing aggregate demand, economists use the real exchange rate rather than the nominal exchange rate.
Rising domestic real GDP drives demand for imported goods, reducing net exports and vice versa.
Meanwhile, falling prices for domestic goods (possibly due to currency depreciation) make these goods cheaper for foreigners, thereby increasing net exports.
How the aggregate demand affects aggregate supply
Aggregate demand is a key concept in Keynesian economics. In this concept, the government must strive to stimulate aggregate demand to ensure full employment. Increasing aggregate demand is a necessary condition for an increase in aggregate supply.
However, the increase in aggregate demand is not an adequate condition, unless an economy has spare capacity to produce the demanded goods and services. In short, increasing aggregate demand cannot boost aggregate output when the productive capacity of the economy is fully utilized.
Any increase in aggregate demand exceeding aggregate supply will only increase imports. And, if additional supplies for goods are unavailable at all, inflationary pressures arise.
Aggregate demand curve and its determinants
The aggregate demand curve has a downward slope, which means that the real GDP decreases when the price level increases.
Movement along the curve occurs due to changes in the price level. Meanwhile, changes in factors other than the price level shift the aggregate demand curve. A shift to the right means an increase in aggregate demand, while a shift to the left indicates a decrease.
The following are the factors that influence aggregate demand and its curve:
- Consumer expectations of future income
- Consumer wealth
- Business expectations
- Capacity utilization
- Monetary policies such as interest rates and open market operations
- Fiscal policies such as government spending and taxes
- Exchange rate
- Global economic growth
Future income expectations
When consumers believe future disposable income will increase, they tend to save less and increase current consumption. They are optimistic about their future income and job security.
This situation usually occurs during economic expansion. An increase in consumption spurs AD and shifts the curve to the right.
Wealth
In addition to income, changes in current spending can also be attributed to changes in consumer wealth. Wealth can take the form of financial assets such as stocks, bonds, mutual funds, and real assets such as property and land.
If the value of these assets rises, consumers tend to increase their current spending and save less, shifting the curve to the right.
Business expectations
Businesses delay capital investment if they are less optimistic about future growth and profitability. Usually, it happens during a recession. In this situation, demand prospects for goods are sluggish, thus weakening their sales and profits outlook.
But as the economy expands, businesses are more confident about their sales prospects. Strong demand convinces them to get better profits and to increase production capacity. They then order physical capital to increase production.
Capacity utilization
Capacity utilization measures how production capacity is fully utilized. When companies produce at or near full capacity, they need to expand production. For this reason, they will invest in new physical capital. Increased investment shifts the aggregate demand curve to the right.
Conversely, excess capacity makes companies have little incentive to invest in property, factories, or new equipment. They acknowledged it would be more profitable to optimize the current production capacity.
Monetary policy
The central bank has several instruments to influence the aggregate demand, including policy rates, market operations, and reserve requirements. To increase aggregate demand, the central bank will loosen monetary policy (expansionary monetary policy), which will increase the money supply in the economy, giving commercial banks more funds to lend.
An increase in the money supply pushes down interest rates in the economy. Lower interest rates reduce investment costs, leading businesses to buy capital goods.
On the other hand, lower interest rates and greater availability of credit also encourage consumer spending on items purchased on credit, such as durable goods. As a result, higher consumption and investment shifts the curve to the right.
Fiscal policy
Governments can influence aggregate demand through fiscal policy by changing government spending and taxes. It is an expansionary policy if the government increases its spending or cuts taxes. Conversely, reducing expenditure or raising taxes is a contractionary policy.
Expansionary fiscal policy will increase AD, while contractionary will lead to a lower AD.
Let’s assume the government is cutting tax rates. A low tax rate makes consumers pay less taxes and have more money to spend on goods and services. As a result, higher consumer spending contributes to shifting the curve to the right.
Exchange rates
Domestic currency depreciation makes domestic goods cheaper for foreigners, thereby increasing their demand. It spurs exports. On the side, depreciation also makes the price of imported goods more expensive for domestic buyers. It should reduce imports. This net effect of increased exports and decreased imports tends to boost aggregate demand.
The opposite effect will occur when the currency appreciates. Domestic goods will be more expensive for foreigners, and imported goods will be cheaper for domestic consumers.
Global economic growth
Strong global economic growth is driving more demand for domestic goods and services. This increases exports and aggregate demand. In contrast, when the global economy weakens, exports tend to be depressed.
The accelerator effect and aggregate demand
The accelerator effect is an economic concept that describes the amplified impact of changes in consumer spending on investment and, ultimately, aggregate demand. It highlights the interconnectedness between these factors and how they can create a ripple effect throughout the economy.
Here’s how it works:
Imagine a scenario where consumer confidence is high and disposable income rises. This can lead to a significant increase in demand for goods and services. This initial increase in demand creates a positive outlook for businesses, who may respond by increasing production, hiring more workers, and expanding their operations.
Businesses anticipate continued growth in demand and decide to invest in additional capital equipment, such as new machinery or factories, to meet the expected rise in production needs. This increased investment spending injects additional money into the economy.
The investment spending by businesses creates a further demand for goods and services, not just for consumer products, but also for raw materials, construction services, and other inputs needed to build the new capital equipment. This secondary demand creates opportunities for other businesses, further stimulating investment and economic activity.
The combined effect of the initial rise in consumer spending and the amplified investment activity leads to an overall increase in aggregate demand. This can lead to higher production levels, job creation, and economic growth.
Impact on economic growth
A strong accelerator effect can significantly contribute to economic growth. Increased investment leads to a rise in production capacity, which allows businesses to meet the growing demand for goods and services. This expansion creates new jobs and boosts overall economic activity.
However, it’s important to consider potential drawbacks:
- Overinvestment: If the initial rise in consumer spending is short-lived or overly optimistic, businesses might overinvest in capital goods. This can lead to excess capacity and a potential economic slowdown if demand doesn’t continue to rise.
- Inventory adjustments: Businesses might also adjust their production based on inventory levels. If they find themselves with excess inventory due to a sudden drop in consumer spending, they can cut back on investment, dampening the accelerator effect.
The accelerator effect highlights the interconnectedness of consumer spending, investment, and economic growth. By understanding this relationship, policymakers can implement strategies to encourage moderate and sustainable growth in aggregate demand.
