In economics, aggregate demand is the total demand for final goods and services in the economy (Y) at a given time and price level. This is the demand for the gross domestic product of a country when inventory levels are static. It is often called effective demand or abbreviated as 'AD'. In a general aggregate supply-demand chart, the aggregate demand curve (AD) slopes downward (indicating that higher outputs are demanded at lower price levels).

Components

An aggregate demand curve is the sum of individual demand curves for different sectors of the economy. The aggregate demand is usually described as a linear sum of four separable demand sources.

Yd = C + I + G + (X-M) \

where

• C \ is consumption = ac + bc*(Y - T),
• I \ is Investment,
• G \ is Government spending,
• NX = X - M \ is Net export,
  • X \ is total exports, and
  • M \ is total imports = am + bm*(Y - T),.

These four major parts, can be stated in either 'nominal' or 'real' terms are:

• personal consumption expenditures (C) or "consumption," demand by households and unattached individuals; its determination is described by the consumption function. The consumption function is C= a + (mpc)(Y-T)
  • a is autonomous consumption, mpc is the marginal propensity to consume, (Y-T) is the disposable income.

• gross private domestic investment (I), such as spending by business firms on factory construction. This includes all private sector spending aimed as the production of some future consumable.
  • In Keynesian economics, not all of gross private domestic investment counts as part of aggregate demand. Much or most of the investment in inventories can be due to a short-fall in demand (unplanned inventory accumulation or "general over-production"). The Keynesian model forecasts a decrease in national output and income when there is unplanned investment. (Inventory accumulation would correspond to an excess supply of products; in the National Income and Product Accounts, it is treated as a purchase by its producer.) Thus, only the planned or intended or desired part of investment (Ip) is counted as part of aggregate demand. (So, I does not include the 'investment' in running up or depleting inventory levels.)
  • Investment is affected by the output and the interest rate (i). Consequently, we can write it as I(Y,i). Investment has positive relationship with the output and negative relationship with the interest rate. For example, when Y goes up, the investment will increase.

• gross government investment and consumption expenditures (G).
• net exports (NX and sometimes (X-M)), i.e., net demand by the rest of the world for the country's output.

In sum, for a single country at a given time, aggregate demand (D or AD) = C + Ip + G + (X-M).

These macrovariables are constructed from varying types of microvariables from the price of each, so these variables are denominated in (real or nominal) currency terms.

Two Concepts of the "Aggregate Demand Curve"

Understanding of the aggregate demand curve depends on whether it is examined based on changes in demand as income changes, or as price change.

Keynesian Cross

In the "Keynesian cross diagram," a desired total spending (or aggregate expenditure, or "aggregate demand") curve (shown in blue) is drawn as a rising line since consumers will have a larger demand with a rise in disposable income, which increases with total national output. This increase is due to the positive relationship between consumption and consumers' disposable income in the consumption function. Aggregate demand may also rise due to increases in investment (due to the accelerator effect), while this rise is reduced if imports and tax revenues rise with income. Equilibrium in this diagram occurs where total demand, AD, equals the total amount of national output, Y, (which corresponds to total national income or production). Here, total demand equals total supply.

In the diagram, the equilibrium level of output and demand is determined where this desired spending curve intersects a line that represents the equality of total income and output (AD=Y). The intersection gives the equilibrium output, Y.

The movement toward equilibrium is mostly via changes in inventories inducing changes in production and income. If current output exceeds the equilibrium, inventories accumulate, encouraging businesses to cut back on production, moving the economy toward equilibrium. Similarly, if the level of production is below the equilibrium, then inventories run down, encouraging an increase in production and thus a move toward equilibrium. This equilibration process occurs when the equilibrium is stable, i.e., when the AD line is steeper than the AD=Y line.

The equilibrium level of output determines the equilibrium level of employment in the model. (In a dynamic view, these are connected by Okun's Law.) There is no reason within the model why the equilibrium level of employment should correspond to full employment. Bringing in other considerations may imply this correspondence, though.

If any of the components of aggregate demand (C + Ip + G + NX) rises at each level of income, for example because business becomes more optimistic about future profitability, that shifts the entire AD line upward. This raises equilibrium income and output. Similarly, if the elements of AD fall, that shifts the line downward and lowers equilibrium output. (The AD=Y line does not shift under the definition used here).

Aggregate Demand-Aggregate Supply model

Sometimes, especially in textbooks, "aggregate demand" refers to an entire demand curve that looks like that in a typical Marshallian supply and demand diagram.

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External links

• Elmer G. Wiens: Classical & Keynesian AD-AS Model - An on-line, interactive model of the Canadian Economy.
• Greg Mesaros: How US Manufacturers are Using Demand Aggregation to Increase Sales & Lower Costs - Real-time demand aggregation in a B2B application over the Internet.

References