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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 by market values, it only represents total output at a given price level and does not necessarily represent quality or standard of living.

BREAKING DOWN 'Aggregate Demand'

As a macroeconomic term describing the total demand in an economy for all goods and services at any given price level in a given period, aggregate demand necessarily equals gross domestic product (GDP), at least in purely quantitative terms, because the two share the same equation. As a matter of accounting, it must always be the case that the aggregate demand and GDP increase or decrease together.

Technically speaking, aggregate demand only equals GDP in the long run after adjusting for the price level. 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” for simplicity. Other variations in calculations can occur depending on methodological variations or timing issues in gathering statistics.

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.

Calculating Aggregate Demand

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

Where:

  • C = Consumer spending on goods and services
  • I = Private investment and corporate spending for non-final capital goods (factories, equipment, etc.)
  • G = Government spending for public goods and social services (infrastructure, Medicare, etc.)
  • Nx = Net exports (exports minus imports)

This is the same formula used by the Bureau of Economic Analysis to measure GDP. 

Illustrating Aggregate Demand

If you were to represent aggregate demand graphically, the aggregate amount of goods and services demanded is represented on the horizontal X-axis, and the overall price level of the entire basket of goods and services is represented on the vertical Y-axis.

The aggregate demand curve, like most typical demand curves, slopes downward from left to right. Demand increases or decreases along the curve as prices for goods and services either increase or decrease. Also, the curve can shift due to changes in the money supply, or increases and decreases in tax rates.

Factors That Can Affect the Aggregate Demand Curve

The following are some of the key economic factors that can affect the aggregate demand curve:

  • Currency exchange rate changes: If the value of the U.S. dollar falls (or rises), foreign goods will become more (or less expensive). Meanwhile, goods manufactured in the U.S. will become cheaper (or more expensive) for foreign markets. Aggregate demand will, therefore, increase (or decrease). 
  • Changes in real interest rates: This will affect decisions made by consumers and businesses when it comes to capital goods. Lower real interest rates will lower large items (such as vehicles and homes), and business capital project spending will increase — making the aggregate demand curve shift down and to the right. Higher real interest rates will raise the costs of goods and project spending, making the curve shift up and to the left. 
  • Wealth: Should the wealth of a household increase (or decrease), demand will also increase (or decrease).
  • Changes in inflation expectation: Should consumers feel that inflation will increase, later on, they may tend to make purchases now, which means the aggregate demand will rise. But if consumers believe prices will drop in the future, aggregate demand will then drop at present, with the curve shifting up and to the left. 

Aggregate Demand Controversy

Boosting aggregate demand also boosts the size of the economy regarding 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 only echoes that they increase concurrently. The equation does not show which is the cause and which is the effect.

And this is the subject of major debates in economic theory.

Early economic theories hypothesized that production is the source of demand. The 18th-century French classical liberal economist Jean-Baptiste Say stated that consumption is limited to productive capacity and that social demands are essentially limitless, a theory referred to as Say's law.

Say's law ruled until the 1930s, with the advent of the theories of British economist John Maynard Keynes. Keynes, by arguing that demand drives supply, placed total demand in the driver's seat. Keynesian macroeconomists have since believed that stimulating aggregate demand will increase real future output. According to their demand-side theory, the total level of output in the economy is driven by the demand for goods and services and propelled by money spent on those goods and services. In other words, producers look to rising levels of spending as an indication to increase production.

Keynes considered unemployment to be a byproduct of insufficient aggregate demand because wage levels would not adjust downward fast enough to compensate for reduced spending. He believed the government could spend money and increase aggregate demand until idle economic resources, including laborers, were redeployed.

Other schools of thought, notably the Austrian School and real business cycle theorists, hearken back to Say. They 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.

Keynes further argued that individuals can end up damaging production by limiting current expenditures – say, by hoarding money. Other economists argue that hoarding changes prices but does not necessarily change capital accumulation, production or future output. In other words, the effect of an individual's saving money – more capital available for business – does not disappear on account of lack of spending.

Aggregation Problem

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

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