Aggregate Demand

Aggregate demand (AD) is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels.
Aggregate means ‘total’ and in this case we use the term to measure how much is being spent by all consumers, businesses, the government and people and firms overseas.

Just like how we draw demand curve of individuals, we can draw the demand curve for the whole economy. When we do so, we call it the ‘Aggregate Demand Curve’.
ADCurve

This diagram shows the downward sloping Aggregate demand curve. AD curve is not always a straight line. Many argue that AD curve is actually a rectangular hyperbola.

hyperbolaAD

The total amount spent is likely to be fairly constant along the AD, and therefore the area under
the AD is likely to remain fairly constant, as in the rectangular hyperbola.

There are various reasons why the AD curve is sloping downwards.

One reason is that, at higher prices, an economy’s export is likely to decrease and imports tend to increase. That means the total net exports(X-M) will decrease => see below for the components of AD.

Another argument for the downward sloping AD is that at higher prices the interest rate is likely to be higher, meaning that investment (a component of AD) is lower. They might also save more.

Components of Aggregate Demand

Aggregate demand (AD) = total spending on goods and services

AD = C + I + G + (X-M)

C: Consumption, this includes demand for durables e.g. audio-visual equipment and motor vehicles & non-durable goods such as food and drinks which are “consumed” and must be re-purchased.

I: Capital Investment – This is spending on capital goods such as plant and equipment and buildings to produce more consumer goods in the future. Investment also includes spending on working capital such as stocks of finished and semi-finished goods.

G: Government Spending – This is spending on state-provided goods and services including public goods and merit goods .

Government spending is by central and local government on goods and services. While to some extent this spending is determined by the fiscal policy of the government, it is also largely dependent upon the business cycle. In a boom, tax receipts increase and the demands on government spending will fall, and vice versa in an economic slowdown.
Changes in G are likely to have a large multiplier effect, in that the spending changes have a direct impact upon the spending in the economy.

(X-M) = Exports – Imports: Net exports measure the value of exports minus the value of imports. When net exports are positive, there is a trade surplus (adding to AD); when net exports are negative, there is a trade deficit (reducing AD).

Next topic: Aggregate Supply

Leave a Comment