Aggregate demand is often seen as the key driver of growth in an economy. As a macroeconomic aggregate it includes the demand for goods, services and investments from all sectors within an economy, and from overseas.
More specifically, aggregate demand, or AD for short, is the sum of consumer spending, and spending by firms on capital goods like machinery, equipment, and premises. It also includes spending by the public sector on public and merit goods, such as roads, bridges and defense, and education and healthcare.
Aggregate demand also includes spending by overseas consumers and firms on an economy’s goods and services – such as when US citizens buy UK produced computer games. Household consumption is the most important component of aggregate demand, making up around 65% of national income in most advanced economies.
There is a simple formula for AD, which is: AD = C + I + G + [X - M] - Aggregate demand equals consumption, plus investment, plus government spending, plus exports minus imports.
AD is negatively related to an economy’s price level, and the AD curve slopes downwards.
At a higher price level, consumption (C) Investment (I) and export sales (X) are LOWER [and Imports [M] are higher], creating a lower national output (at Y1). At a lower price level, (C) (I) and (X) are HIGHER [and M is lower], creating a higher national output [at Y2].
Aggregate demand analysis is part of the AD-AS framework for understanding how a country's national income is determined, along with aggregate supply.
The components of aggregate demand can be analysed separately:
Household consumption is the single largest component of AD. Consumption (C) is determined by several factors, including:
Investment is undertaken by firms when they purchase capital equipment or hold stocks which are waiting to be converted into goods. In national income accounts, investment represents the most volatile element - volatility can largely be explained through the 'accelerator effect'. Gross investment is total investment including the purchase of new capital and capital to replace old technology or equipment.
Factors affecting investment include:
Government spending can be broken down into two categories – current and capital spending - both of which add to aggregate demand. Government spending tends to act as a stabilising mechanism. For example, if aggregate demand from household spending is falling, with the result that unemployment increases, welfare transfers in the form of unemployment benefit will increase, which may offset the negative effect of falling household spending.
Also, spending on merit goods such as education and welfare tends to be relatively stable and hence 'sheltered' from other changes in aggregate demand. It is clear that government spending can have a counter-cyclical effect on aggregate demand.
Several factors affect net exports, including relative exchange rates. A rise in the exchange rate will reduce import prices, but increase export prices. The impact of this depends upon the relative elasticity of imports and exports. The Marshall-Lerner condition states that a change in the exchange rate of a currency will only impact on net trade flows if the price elasticities of imports and exports is great than 1.0. We tend to assume that this condition is met, and hence a fall in rates will stimulate exports and constrain imports to the extent that net trade increases, and aggregate demand increases.
Growth in national income will also affect net exports. Given that imports (M) tend to be a function of national income (Y), any increase in GDP will increase imports relative to exports.
Finally, inflation may have an effect on net exports as it will increase export prices, and make imports relatively more attractive.
Changes in any of these components will shift the position of the AD curve. Elements that increase AD shift the AD curve to the right (as with AD1) and elements that decrease AD shift the curve to the left, at AD2.