Aggregate demand is a macro-economic concept representing the total demand for goods and services in an economy. This value is often used as a measure of economic well-being or growth.
Fiscal policy affects aggregate demand through changes in government spending and taxation. Government spending and taxation influence employment and household income, which dictate consumer spending and investment. Monetary policy impacts the money supply in an economy, which influences interest rates and the inflation rate. Also, monetary policy impacts business expansion, net exports, employment, the cost of debt and the relative cost of consumption versus saving.
Aggregate demand measures the demand for an economy's gross domestic product (GDP). This value is calculated by the following equation:
AD = C + I + G + NX, where
AD refers to aggregate demand, C refers to total consumer spending, I refers to total investment, G refers to government expenditure and NX refers to net exports (total exports - total imports).
The number of goods and services demanded at a given time has an inverse relationship with the price level of those goods and services in total.
Fiscal policy determines government spending and tax rates. Expansionary fiscal policy, usually enacted in response to recessions or employment shocks, increases government spending in areas such as infrastructure, education and unemployment benefits. According to Keynesian economics, these programs prevent a negative shift in aggregate demand by stabilizing employment among government employees and people involved with stimulated industries. Extended unemployment benefits help stabilize the consumption and investment of individuals who become unemployed during a recession. (For related reading, see: What are some examples of expansionary fiscal policy?)
Contractionary fiscal policy can be utilized to reduce government spending and sovereign debt or to correct out-of-control growth fueled by rapid inflation and asset bubbles. In relation to the above equation for aggregate demand, fiscal policy directly influences the government expenditure element and indirectly impacts the consumption and investment elements.
Monetary policy is enacted by central banks by manipulating the money supply in an economy. The money supply influences interest rates and inflation, both of which are major determinants of employment, cost of debt and consumption levels. Expansionary monetary policy entails a central bank either buying Treasury notes, decreasing interest rates on loans to banks or reducing the reserve requirement. All of these actions increase the money supply and lead to lower interest rates. This creates incentives for banks to loan and businesses to borrow. Debt-funded business expansion positively affects consumer spending and investment through employment, thereby increasing aggregate demand. (For related reading, see: What are some examples of expansionary monetary policy?)
Expansionary monetary policy also typically makes consumption more attractive relative to savings. Exporters benefit from inflation as their products become relatively cheaper for consumers in other economies. Contractionary monetary policy is enacted to halt exceptionally high inflation rates or normalize the effects of expansionary policy. Tightening the money supply discourages business expansion and consumer spending and negatively impacts exporters, reducing aggregate demand.
(For related reading, see: What Factors Cause Shifts in Aggregate Demand?)