Aggregate DemandDefined with Formula & More

Written By:
Lisa Borga

Aggregate demand is a term that is commonly used in macroeconomics.

Aggregate demand is the total demand for final goods and services at a given price level in a specified period.

When looked at over a long period of time, aggregate demand will be equal to the gross domestic product (GDP) due to the fact that both of these metrics are computed by the same process.

The gross domestic product shows the total value of the services and goods that a country produces in a one-year period.

Whereas aggregate demand is the demand for the goods and services that were produced.

Because these metrics are computed in the same way, they will both increase or decrease at the same time.

Although, aggregate demand will actually only be equal to GDP in the long term if the price level is adjusted.

This adjustment is necessary due to the fact that short-run aggregate demand is a measurement of the total output at a given price level before inflation is accounted for.

Aggregate demand accounts for all final goods.

This includes exports, imports, capital goods, as well as spending programs by the government.

Issues with Aggregate Demand

Aggregate demand is useful for determining how strong businesses and consumers are in the economy, but it has some weaknesses.

Because aggregate demand is determined by using market values, it depicts total output solely at a specific price level and does not purport to indicate a country’s standard of living or the quality of life of its people.

Additionally, since aggregate demand measures the demand of so many different transactions for so many people, it can be hard to determine the cause of the demand or conduct a regression analysis.

Aggregate Demand Curve

The aggregate demand curve shows the demand for services and goods that are produced domestically at every price level.

This curve is downward sloping because there is less demand for goods and services at higher prices which is consistent with the law of demand.

There are some reasons for this downward slope, such as:

• Exchange Rate Effect: When the value of the currency of one country becomes lower than other countries, domestic goods become relatively less expensive for people in this country. Also, imported goods become more expensive. Thus, when price levels are low and domestic goods are less costly than imports, there will be greater demand for exports, and aggregate demand will increase.
• Pigou’s Wealth Effect: According to Pigou’s Wealth Effect, consumers have more wealth when price levels are lower. Consumers have more disposable income when price levels are lower, meaning they have more money to spend on goods and services, which increases demand for output.

The Equation for Aggregate Demand

Aggregate demand is determined by taking the sum of the individual demand curves from the different sectors making up the economy.

The equation for aggregate demand is:

Aggregate Demand=C+I+G+Nx

Where:

C = Consumption Spending:

This is the largest part of the economy’s aggregate demand.

It is the total amount households and individuals spend on goods and services.

This spending will depend on a number of factors, such as debt, per capita income, interest rates, disposable income, and what consumers expect future economic conditions to be.

Spending on residential structures is not included in consumption spending because it is part of investment spending.

I = Investment Spending.

This includes the total amount spent on new capital services and goods, including investments in residential and non-residential structures, machinery, changes in inventory, and equipment.

There are some factors that will affect this, such as government incentives, interest rates, and future expectations for the economy.

G = Government Spending

Government spending is the entire amount the government spends on public sector facilities, government employees, healthcare services, infrastructure, defense and military equipment, and investments.

Government spending does not take into account the amount spent on transfer payments, such as aid transfers to foreign countries and pension plans.

Nx = Net Exports

Exports are goods that are made by domestic companies and then sold in foreign countries.

Imports are produced in foreign countries and imported to be sold domestically.

Since aggregate demand is the demand for goods and services that are produced domestically, exports are included, and imports are subtracted.

Net exports are a country’s exports minus its imports and are an important component of aggregate demand.

Factors That Have an Effect on Aggregate Demand

There are a number of factors that can influence aggregate demand, such as:

• Income: If real wages increase, workers will have more money to spend. This means the workers will likely increase their spending, causing consumption to increase.
• Interest Rates: Interest rates affect the spending decisions of businesses and consumers. When interest rates are lower, it costs less for businesses to borrow money for capital spending. The borrowing costs for consumers who want to purchase big-ticket items are lower as well.
• Exchange Rates: If a country’s exchange rate goes up, then net exports will go down. Also, aggregate expenditures will decrease at any price. Therefore, aggregate demand will decrease.
• Expectations: If consumers think that inflation or prices will be rising, they tend to make purchases which will cause aggregate demand to increase. Whereas if consumers believe that prices will be falling, aggregate demand tends to decrease.

How is Aggregate Demand Related to GDP?

Gross domestic product is a measure of the market or monetary value of all of the final goods and services produced within a country in a certain time period.

Therefore, the GDP is actually the aggregate supply for the country.

Aggregate demand will be the total demand for the final goods and services.

Eventually, the aggregate demand will be equal to the GDP since these metrics are computed in the same manner; thus, GDP and aggregate demand will rise and fall together.