What is Aggregate Demand?

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Definition:

Aggregate demand is an economic concept that measures the total market for every good and service that an economy produces.

🤔 Understanding aggravate demand

Economists often estimate the level of supply and demand for individual products or services. For example, there might be enough demand for new smartphones that a manufacturer could sell 100,000 phones each month. Economists usually express supply and demand in unit amounts or dollar amounts. Aggregate demand, however, finds the total sum of the market for every single product and service that an economy produces and expresses it as a total dollar value. For example, a country could have an aggregate demand for goods and services equal to $1B per year.

Example

Let’s use the fictional country of Foodtopia as an example. In Foodtopia, consumers only want to buy breakfast, lunch, and dinner.

The demand for breakfast foods in Foodtopia is $1M. For lunch, it’s $2M. Foodtopians also demand $5M worth of dinner.

The aggregate demand for the economy of Foodtopia is, therefore, $8M — the sum of the need for every good that the consumers demand.

Takeaway

Aggregate demand is like measuring how many apples you consume…

You can’t just count the whole apples you eat. You have to count every slice of apple pie, every cup of applesauce, and every box of apple juice, as well. All of these individual apple-based foods when added together constitute your total consumption of apples. In the same way, aggregate demand first measures the market for each particular good or service in an economy then finds the sum of those demands.

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What is Aggregate Demand?

Aggregate demand measures the total level of demand in an economy.

Economists often measure the level of supply and demand for specific goods or services. Using supply and demand curves, they can determine how any changes will impact the price of a product. Usually, they express the demand for a good as the total dollar value of the product.

Aggregate demand takes the demand for every good produced by an economy and combines it into a single dollar amount. It includes the foreign demand for products produced domestically but excludes the domestic market for foreign-made items.

Aggregate demand relates very closely to Gross Domestic Product (GDP). GDP measures the total value of everything that a country makes. Aggregate demand estimates the overall consumer demand for those goods and services and what they’ll pay for them. In theory, the total value of the things a country makes should equal the prices that consumers are willing to pay for those things. Economists often adjust these numbers for inflation to find real GDP and real aggregate demand.

Why is aggregate demand important?

One reason that aggregate demand is significant is that it gives economists a tool for measuring the strength of an economy. Usually, economists estimate the total market for items produced in an economy over a year. If aggregate demand is high, then the economy is strong — meaning it can sell many products. If it’s low, however, the economy will likely have trouble moving goods in the market, signaling a potential downturn.

Changes in aggregate demand also illustrate the changing nature of an economy. If it’s rising, the economy is getting stronger overall. A shrinking aggregate demand indicates an economy that is getting weaker.

Instead of using exchange rates, economists can also use aggregate demand to analyze a country’s position in international trade. Because aggregate demand includes the foreign demand for domestically produced goods, high aggregate demand can indicate a nation with strong exports.

It’s also a strong indicator of employment levels. As the demand for goods increases, unemployment should fall as businesses work to increase production. If the market shrinks, unemployment rises. While all markets undergo cyclical changes and volatility, trends in total demand should show the direction that unemployment will trend over the long-term.

This theory explains why governments tend to increase spending during financial crises — Increased government spending tends to increase the total demand for goods. This, in turn, should lead to rising employment levels over the long-term.

What is the aggregate demand curve?

Economists often use supply and demand curves to illustrate how changes in price, supply, or demand affect each other. For example, decreased supply typically leads to a higher price, reducing demand until things arrive back at equilibrium.

Aggregate demand curves show how price levels affect total spending on domestically produced goods. The X-axis shows total spending, and the Y-axis shows the price levels.

Typically, the total demand curve slopes downward. As prices increase, aggregate demand falls, and if costs decrease, the overall demand for goods increases. Economists can use aggregate demand curves alongside total supply curves to find the ideal pricing levels for an economy.

What factors affect aggregate demand?

Four factors determine the aggregate demand of an economy: net exports, inflation, interest rates, and expectations of inflation.

Net exports

Net exports are the number of a country’s exports minus its imports. The higher a country’s net exports (exports minus imports), the higher its aggregate demand. If foreign consumers want to buy goods that one country makes, that country’s aggregate demand increases. Similarly, if domestic residents want to purchase international products instead of those made locally, the total demand in that country decreases.

Price levels have a significant effect on net exports. Cheaper products are often more desirable both locally and abroad, so decreasing prices increase net exports and vice versa.

Inflation

Inflation means that money tends to lose value over time. If cash becomes less valuable, the total level of real (inflation-adjusted) spending tends to drop unless a corresponding increase in income levels accompanies it. Since people have less spending power, aggregate demand decreases.

Interest rates

When interest rates are low, there is little reason for consumers or businesses to save money and higher incentives to borrow money while the cost of borrowing is low. If interest rates drop, people will spend more, increasing the aggregate demand. If rates rise, more people will save their money and reduce the size of the market.

Expected inflation

Consumer behavior can change based on future expectations of inflation. If people anticipate high levels of inflation, they’re more likely to spend money now when their cash is valuable than to save it and allow it to lose value. This increases aggregate demand in the short run.

If consumers expect low levels of inflation or even deflation, there’s more reason to save their money and wait to spend it in the future, reducing demand.

What is the difference between aggregate demand and demand?

The primary difference between aggregate demand and demand is that the former explains the total demand for goods and services produced by an economy. Demand describes the market for a specific product. Aggregate demand is a function of the individual market for every product in a marketplace.

Aggregate demand is affected by macroeconomic factors such as inflation, exports, and interest rates. Microeconomic concepts like income levels and the availability of substitutes determine the demand for individual products.

What is the difference between aggregate demand and aggregate supply?

Aggregate demand shows the total cumulative demand for everything that an economy produces. That includes both domestic demand for products created and foreign demand for those exported goods.

Aggregate supply explains the total output of a country’s economy. In other words, it shows everything that the people and businesses in a country plan to make and sell to consumers, regardless of where those consumers live.

Typically, a graph depicts price on the Y-axis and supply on the X-axis, with the aggregate supply curve on an upward sloping curve. As prices increase, businesses tend to make more goods in order to increase revenue. On the same graph, aggregate demand usually slopes downward. As prices drop, people demand more products.

The two curves intersect at the equilibrium point, where the supply meets all demand that the economy produces.

How is aggregate demand calculated?

You can calculate aggregate demand using a formula that’s nearly identical to the formula for calculating Gross Domestic Product.

The formula for aggregate demand is:

Government spending

Government spending covers all of the cash that the government spends domestically during a period. For example, government spending on welfare, social assistance, infrastructure, the military, education, and social services all increase aggregate demand.

This is why many economists recommend increased government spending to deal with a weakening economy and high unemployment. Increased aggregate demand tends to strengthen an economy, and spending in turn increases demand.

Investment

Investment refers to business spending on major capital projects — For example, a factory spending money on new machinery or a car manufacturer building a new plant to build vehicles.

Levels of business investment can change with interest rates and business confidence in the economy. Government policy also affects investment. Systems that provide tax benefits for business investment will encourage companies to spend money on investment.

Things that discourage businesses from spending money, like high interest rates, corruption, or bureaucracy, can reduce business investment, which also reduces aggregate demand.

Consumption

Consumption is likely the best-known determiner of aggregate demand. It refers to the amount that regular consumers spend on products. Everything you buy, from groceries to concert tickets to electronics, is part of consumption. In most economies, it’s one of the most substantial pieces of aggregate demand.

Many different factors affect consumption. One of the most basic is income. The more money the average consumer makes, the more they can spend in the economy. Similarly, average levels of wealth affect spending because people with more resources can buy more.

Conversely, consumer debt affects spending because higher levels of debt mean that consumers have less money to spend. If average consumer debt is high, they’ll usually spend more money on interest and less on new purchases.

Consumer confidence is also a significant factor in consumption levels. If consumers feel confident about their job prospects and the security of their income, they’re more willing to spend money. People who are worried about the future tend to save money and reduce their consumption.

Net exports

Net exports are the total value of products that a country sells to other nations, minus the cost of products that the nation imports from elsewhere. This number can be positive or negative. If it’s positive, then it contributes to increasing aggregate demand. If it’s negative, it reduces aggregate demand.

What are the limitations of aggregate demand?

Aggregate demand shows the total level of consumer demand for products produced by an economy but fails to show other important economic information.

For example, a high level of aggregate demand should indicate a healthy economy because it can produce and sell many goods. However, aggregate demand doesn’t show how well the economy distributes the rewards from that high level of demand. A strong economy with high levels of inequality and a strong economy with great equality will look the same when you view their aggregate demand curve.

Aggregate demand also fails to describe the standards of living in an area. It’s only concerned with the value of products that an economy sells.

Quality is also left out of the calculation of total demand. Quality does have some impact on the price businesses can charge, but the calculation fails to tell the whole story. Two economies can have very similar aggregate demands even if one sells low-quality products and the other sells fewer but much higher quality items.

Because aggregate demand is a macroeconomic concept, it isn’t useful for answering many economic questions. For example, you cannot use aggregate demand to determine why the need for a particular product or type of products increased, even if that increase had a significant effect on aggregate demand.

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