Aggregate demand

Aggregate demand is often seen as the key driver of growth in an economy. As a macroeconomic aggregate it refers to the total 'planned' demand for goods, services and investments from all sectors within an economy, and from overseas, in a given period of time.

Discover why the AD curve slopes downwards

The components

Aggregate demand, or 'AD', is measured by adding together the monetary value of spending by all economic 'agents' in both the private and public sector of an economy, and includes spending by households on consumer goods - including durable and non-durable goods - and 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.

The formula

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.

The model - AD and the price level

When building a model of aggregate demand, economists start by considering how the different components respond to changes in the price level. To do this, all other factors that might influence aggregate demand are held constant. For example, monetary influences on spending are likely to include interest rates and exchange rates, but these are held constant for the purposes of identifying how spending is affected by the price level. Once this relationship is established, other factors can be inserted into the model.

The relationship between aggregate demand and the price level in inverse (or 'negative'), so that, at a higher price level aggregate demand will have a lower value. The curve plotting this - the aggregate demand curve - will slope down from left to right.

At a higher price level, consumption (C) investment (I) and export sales (X) are lower [and imports [M] are higher], creating a lower value of aggregate demand. At a lower price level, (C) (I) and (X) are higher [and M is lower], creating a higher value of aggregate demand.

Hypothetical example

The schedule below shows the value of the components of aggregate demand (C, I, G and X-M) at different price levels. The relationship between these components and the price level is inverse.

AD schedule - hypothetical

This relationship can be presented as an aggregate demand curve, with the price level (P) on the 'Y' axis, and the value of aggregate demand on the 'x' axis.

AD schedule - hypothetical

Aggregate demand analysis is part of the AD-AS framework for understanding how a country's national income is determined, along with aggregate supply.


Video on aggregate demand and supply

The components of aggregate demand can be analysed separately:

Household consumption

Household consumption is the single largest component of AD. Consumption (C) is determined by several factors, including:

  1. Incomes – income flowing into households forms the basis of consumption. The marginal propensity to consume indicates how much of new income is allocated to new consumer spending.
  2. Savings – decisions to save affect decisions to spend – more saving means less is available for spending.
  3. Taxation – direct taxes, such as income tax, and other charges, reduce disposable income. Changes in tax rates or tax levels will directly affect what is available for households to spend.
  4. Debt levels – increases in debt are likely to lead to reductions in consumption, and hence aggregate demand.
  5. Wealth levels – increases in levels of wealth, such as increases in the value of property assets and share values are likely to increase household consumption through 'equity withdrawal'. This means that individuals may obtain finance which is backed by property or other assets.
  6. Interest rates – changes in interest rates affect how income is spent. A rise in interest rates will means that credit card and mortgage repayments will increase, leaving less available for spending on other goods and services.
  7. Unemployment – increases in unemployment, such as those resulting from the Covid-19 pandemic, will reduce consumption across an economy.
  8. Confidence – changes in consumer confidence may alter consumers’ patterns and levels of spending. Confidence levels can be assessed through surveys, and the creation of a consumer confidence index, such as the Consumer Confidence Index (CCI) created by the US Conference Board. The OECD produces a general consumer confidence index from data from its members:

Investment

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:

  1. National income – changes in income can trigger larger than proportionate changes in the level of investment through the ‘accelerator’ effect. The extent of this depends upon another determinant – business confidence. If producers believe that an upturn in national income signals a period of growth, then it is likely that they will purchase more capital goods than they need in the short run. Also, capital goods tend to be indivisible – and it may not be possible to increase investment by small and gradual amounts. Hence, an increase in national income of just 3% may trigger a much larger increase in investment.
  2. Interest rates - interest rates can affect investment spending in three related ways. Firstly, capital spending may be funded by borrowing, and hence any change in the borrowing rate may affect the cost of investment, and decisions to investment. Secondly, the interest rate represents an ‘opportunity cost’ to producers. Saving in an interest bearing account is an alternative to spending on capital, and any change in rates alters the opportunity cost of investment. For example, if rates rise from 5 to 7%, capital investment becomes relatively less desirable. Finally, changes in rates affect business confidence – a rise in rates may signal further rises and a period of monetary contraction.
  3. Confidence and expectations - confidence is a significant determinant of investment decision-making. Given that investment is a sacrifice, firms must feel confident that they will get a positive return from their investment.
  4. Policy – finally, government can influence investment though its choice of policies. For example, firms can be given tax relief on its capital spending, and some firms may benefit from subsidies to purchase capital equipment.

Government spending

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.

Net exports (X – M)

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.

AD curve - hypothetical

Why does the aggregate demand curve slope downwards?

There are several explanations of the downward slope of the aggregate demand curve:

The purchasing power of monetary balances

When the price level rises (as in the diagram, from P to P1, and point a to b) the value of consumer holdings of cash, current bank accounts, savings, and other accounts falls. Inflation erodes the value of these balances.

The formua for PED

Assuming no compensating increase in money balances, the real value of these holdings falls – in other words, less can be purchased. The response of households is to cut back on spending. Conversely, a fall in the price level increases these real balances.

The interest rate effect

A rise in the general price level will reduce the value of money balances held in the economy, and assuming individuals, households and firms wish to maintain their purchases, they will be encouraged to borrow to replenish their balances.

This increase in borrowing will raise interest rates, which in turn will reduce spending across the economy.

The trade effect

A rise in the general price level will increase the price of a country’s exports and reduce the price of imports. This encourages domestic households and firms in country X to switch to relatively cheaper imports from country Y, and encourages overseas households and firms in country Y to switch away from more expensive exports from country X. The combined effect is to reduce aggregate demand.


Deriving an AD curve

See the aggregate expenditure model

AD - model  
Fiscal policy

How can fiscal policy influence aggregate demand?

Fiscal policy
Monetary policy

Is monetary policy more effective at controlling inflation?

Monetary policy


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