Aggregate Demand

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What is 'Aggregate Demand'

Aggregate demand is an economic measurement of the sum of all final goods and services produced in an economy, expressed as the total amount of money exchanged for those goods and services. Since aggregate demand is measured through market values, it only represents total output at a given price level, and does not necessarily represent quality or standard of living.

The Keynesian equation for aggregate demand is: AD = C+I+G+(Nx)

Where:

C = Consumer spending

I = Private investment spending for non-final capital goods

G = Government spending

Nx = Net exports

BREAKING DOWN 'Aggregate Demand'

Aggregate demand necessarily equals gross domestic product (GDP), at least in purely quantitative terms, because they share the same equation. As a matter of accounting, it must always be the case the aggregate demand and GDP increase or decrease together.

Technically speaking, aggregate demand only equals GDP in long-run equilibrium. This is because short-run aggregate demand measures total output for a single nominal price level, not necessarily (and in fact rarely) equilibrium. In nearly all models, however, the price level is assumed to be “one.”

Aggregate demand is by its very nature general, not specific. All consumer goods, capital goods, exports, imports and government spending programs are considered equal so long as they traded at the same market value.

Aggregate Demand and Recessions

According to Keynesian demand-side theory, future economic production is propelled by money spent on goods and services. British economist John Maynard Keynes considered unemployment to be a byproduct of insufficient aggregate demand, because wage prices would not adjust downward fast enough to compensate for reduced spending. He believed government could spend money and increase aggregate demand until idle economic resources, including laborers, were redeployed.

This is the subject of major debates in economic theory. Boosting aggregate demand also boosts the size of the economy in terms of measured GDP. However, this does not prove that an increase in aggregate demand creates economic growth. Since GDP and aggregate demand share the same calculation, it is only tautological that they increase concurrently. The equation does not show which is cause and which is effect.

Other schools of thought, notably the Austrian School and real business cycle theorists, stress consumption is only possible after production. This means an increase in output drives an increase in consumption, not the other way around. Any attempt to increase spending rather than sustainable production only causes maldistributions of wealth or higher prices, or both.

Aggregation Problem

Another issue rests with the use of aggregate data in macroeconomics. Aggregate demand measures countless different economic transactions between millions of different individuals and for different purposes. This makes it very difficult to variations, run regressions, or accurately identify collinearity and causality. In statistics, this is referred to as the “aggregation problem” or “ecological inference fallacy.”