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 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 does household save and consume of the additional money they receive, it 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 also need to consider the effect of this variable in the analysis of household consumption. Reduced personal taxes makes households have more money to spend or to 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. But, economists conclude that disposable income is the most dominant factor in explaining consumption. No income means no money for consumption and savings.
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’ investment. 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 expenditures are considered as an exogenous variable. It is because economic variables such as economic growth, currency exchange rates, and interest rates; does not affect spending decisions.
Net exports equal exports minus imports. Exports are foreign demand for domestic output. 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 does aggregate demand affect 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 of 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.
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 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.
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.
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 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 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.
The central bank has several instruments to influence the economy, including policy rates, market operations, and reserve requirements. To increase aggregate demand, the central bank will loosen monetary policy (expansionary monetary policy), which will lead to an increase in the money supply in the economy, making commercial banks have 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.
Governments can influence aggregate demand 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 government cutting tax rates. Low tax rate makes consumers paying less on 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.
Domestic currency depreciation makes domestic goods cheaper for foreigners, thereby increasing their demand. It spurs in exports. On the side, depreciation also makes the price of imported goods more expensive for domestic buyers. It should reduce imports. As a result, net exports tend to increase.
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 increase exports and AD. In contrast, when the global economy weakens, exports tend to be depressed.
What to read next
- Aggregate Demand Curve: Meaning, Sloping Reasons, Determinants
- Aggregate Demand: Formula, Components and Determinants
- Business Confidence: Its Effect on Aggregate Demand and the Economy
- Capacity Utilization: Its Relationship With Profitability, Aggregate Demand and the Economy
- Consumer Confidence: Its Effect on Aggregate Demand and the Economy
- Demand Shock: Definition and a Brief Explanation
- How Exchange Rates Affect Aggregate Demand and the Economy
- How Fiscal Policy Affects Aggregate Demand and the Economy
- How Household Wealth Affects Aggregate Demand and the Economy
- How Monetary Policy Works Affects Aggregate Demand and the Economy