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Aggregate Demand

Aggregate demand means an estimation of the overall demand for all off-the-shelf items manufactured in the economy. It amounts to the total sum of monetary means turned into products and services at a particular price standard and time moment.

Aggregate Demand explained

The concept of aggregate demand refers to the cumulative demand for products and services at any predetermined price level in a certain period. The term can be equal to gross domestic product (GDP) in the long run, as these indicators are calculated in the same manner. In other words, GDP means an overall number of goods and services manufactured in the economic realm, whereas aggregate demand represents a market uptake or request for these commodities. 

From a technical perspective, the mentioned markers are equivalent only in case of correcting price level. It can be associated with short-run aggregate demand that estimates total yield for a certain face value level. At the same time, face value isn’t corrected with respect to inflation. Of course, there are other types of calculations, but this is the most popular one.

Aggregate demand is made up of all consumer items, capital goods with plants and machinery, outward and inward trades, as well as state spending plans. An equation of any variable is reached by carrying on traffic at a particular selling price.

Downsides of the concept

Aggregate demand as an indicator is not without flaws. Among them are the following points: 

  • It doesn’t reflect the standard of living in a society. The metric only indicates the consumption level at a particular moment established for a set of goods and services. To determine the standard of living, indicators such as GDP per capita, or real disposable income of the population come into play.
  • The term covers millions of transactions every day. Therefore, it is difficult to make a comparison between them, in order to identify patterns. In this sense, demand indicators for certain categories of goods will be more relevant.

Aggregate Demand graph

The curve assumes a combination of the price level and the total output of goods and services. These determinants must be in balance, since the level of cash expenditures is fixed. But the spread of these expenses, and their magnitude is different. Of all the points on the graph, only one will determine the balance between supply and demand.

Calculating market uptake

Aggregate demand is the sum of market uptake in all macroeconomic agents, i.e. households, firms, the state and the foreign sector, for final goods and services.

The following formula reflects the way aggregate demand is calculated:

where the metrics signify:

  • G - government purchases of goods and services, or state contracts;
  • I - private investments and corporate expenses;
  • C - consumer expenditures for commodities;
  • Nx - spendings for the foreign sector, i.e. net exports.

Let’s consider the metrics in more detail.

Government procurement. To the extent that public spending items are determined in nominal monetary terms, the real value of government purchases will also fall, when the price level rises.

Investment. An increase in the price standard usually leads to a growth of interest rates. Credit facilities become more expensive, and this deters firms from making new investments. So that the real investment volume diminishes.

Consumption. As the price level rises, real purchasing power falls, causing consumers to feel less wealthy, and, therefore, buy a smaller share of real output.

Net exports. When the price level in one country rises, imports from other states will increase. At the same time, outward trade from the initial country decreases. As a result, there is a trend for real net exports to reduce.

Economic forces having effect on Aggregate Demand

So, there is a need to analyze the key factors affecting aggregate demand, which are the following: 

  1. Interest rates. In addition to the impact through lending activities, the growing debt burden also directly affects the aggregate demand in the economy, since the more money borrowers spend on servicing their obligations, the less monetary means remain to finance their expenses.
  2. Revenues and fortune. In the event that consumers are looking forward to an increase in personal income in the near future, they will now move on to spending a much larger part of it. This situation will shift the aggregate demand curve to the right from the original level. With a reverse perspective, buying action will be limited, and the demand curve will shift to the left.
  3. Inflation prospects. Aggregate demand is very sensitive when inflation hits. Then any consumer will seek to make purchases before the rise in prices.
  4. Currency conversion rates. In case the exchange rate for its own currency increases, then the country is able to buy more foreign goods. This situation, in turn, leads to a growth of aggregate demand.

Real life example

The coronavirus has become a trigger for the economic crisis, the severity and depth of which no one is fully aware of. First of all, the pandemic led to the rupture of economic ties, as well as the closure of borders. This gave rise to supply shock, a phenomenon the world hasn’t experienced for at least half a century. 

The supply shock is superimposed on aggregate demand collapse. It affects the economy through a decrease in market uptake for export goods, as well as a contraction in domestic demand, specifically due to devaluation, and a decrease in the social purchasing power.

Notably, demand and supply shocks imply a different set of anti-crisis measures. In case financial injections make it possible to soften demand constraints, then, in conditions of a supply shock, they cause a phenomenon, called stagflation. This is exactly what happened in the early 1970s, when the U.S. responded to supply collapse triggered by an oil embargo with standard Keynesian money injections. It led to a stagflation and a protracted crisis, from which the West emerged only a decade later.

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