How Are Aggregate Demand and GDP Related?

Gross domestic product (GDP) is a way to measure a nation's production or the value of goods and services produced in an economy. Aggregate demand takes GDP and shows how it relates to price levels.

Quantitatively, aggregate demand and GDP are the same. They can be calculated using the same formula, and they rise and fall together.

Key Takeaways

  • Gross domestic product, or GDP is used as a measure for the size of an economy based on the monetary value of all finished goods and services made within a country during a specific period.
  • Aggregate demand refers to the total amount of money exchanged for those finished goods and services at a specific price level and period of time.
  • Both measures are utilized by macroeconomics, although their usefulness in practice has been called into question by some critics.

Calculating Aggregate Demand and GDP

In general macroeconomic terms, both GDP and aggregate demand share the same equation:

 G D P  or  A D = C + I + G + ( X M ) where: C = Consumer spending on goods and services I = Investment spending on business capital goods G = Government spending on public goods and services X = Exports M = Imports \begin{aligned} & GDP \text{ or } AD = C + I + G + (X - M)\\ &\textbf{where:}\\ &C=\text{Consumer spending on goods and services}\\ &I=\text{Investment spending on business capital goods}\\ &G=\text{Government spending on public goods and services}\\ &X=\text{Exports}\\ &M=\text{Imports}\\ \end{aligned} GDP or AD=C+I+G+(XM)where:C=Consumer spending on goods and servicesI=Investment spending on business capital goodsG=Government spending on public goods and servicesX=ExportsM=Imports

There are three methods for estimating GDP:

  • Measuring the total value of all goods and services sold to final users
  • Adding together income payments and other production costs
  • The sum of all value added at each production stage

Conceptually, all of these measurements are tracking the same thing. Some differences can arise based on data sources, timing, and mathematical techniques used.

GDP, AD, and Keynesian Economics

A Keynesian economist might point out that GDP only equals aggregate demand in long-run equilibrium. Short-run aggregate demand measures total output for a single nominal price level (not necessarily equilibrium). In most macroeconomic models, however, the price level is assumed to be equal to "one" for simplicity.

Keynesian economics is a macroeconomic economic theory based on total spending in the economy and its effects on output, employment, and inflation. Keynesian economics was developed by the British economist John Maynard Keynes during the 1930s in an attempt to understand the Great Depression. Keynesian economics is considered a "demand-side" theory that focuses on changes in the economy over the short run. Keynes’s theory was the first to sharply separate the study of economic behavior and markets based on individual incentives from the study of broad national economic aggregate variables and constructs.  

Potential Issues

GDP and aggregate demand are often interpreted to mean that the consumption of wealth and not its production drive economic growth. In other words, it disguises the structure and relative efficiency of production underneath total expenditures.

Additionally, GDP does not take into consideration the nature of what, where, and how goods are created. For example, it does not distinguish producing $100,000 worth of toenail clippers versus $100,000 worth of computers. In this way, it's a somewhat unreliable gauge of real wealth or the standard of living.