Aggregate demand

Aggregate demand

Overview
In macroeconomics
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...

, aggregate demand (AD) is the total demand for final goods and services in the economy (Y) at a given time and price level
Price level
A price level is a hypothetical measure of overall prices for some set of goods and services, in a given region during a given interval, normalized relative to some base set...

. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....

 of a country when inventory
Inventory
Inventory means a list compiled for some formal purpose, such as the details of an estate going to probate, or the contents of a house let furnished. This remains the prime meaning in British English...

 levels are static. It is often called effective demand
Effective demand
In economics, effective demand in a market is the demand for a product or service which occurs when purchasers are constrained in a different market. It contrasts with notional demand, which is the demand that occurs when purchasers are not constrained in any other market...

, though at other times this term is distinguished.

It is often cited that the aggregate demand curve is downward sloping because at lower price levels a greater quantity is demanded.
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In macroeconomics
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...

, aggregate demand (AD) is the total demand for final goods and services in the economy (Y) at a given time and price level
Price level
A price level is a hypothetical measure of overall prices for some set of goods and services, in a given region during a given interval, normalized relative to some base set...

. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....

 of a country when inventory
Inventory
Inventory means a list compiled for some formal purpose, such as the details of an estate going to probate, or the contents of a house let furnished. This remains the prime meaning in British English...

 levels are static. It is often called effective demand
Effective demand
In economics, effective demand in a market is the demand for a product or service which occurs when purchasers are constrained in a different market. It contrasts with notional demand, which is the demand that occurs when purchasers are not constrained in any other market...

, though at other times this term is distinguished.

It is often cited that the aggregate demand curve is downward sloping because at lower price levels a greater quantity is demanded. While this is correct at the microeconomic, single good level, at the aggregate level this is incorrect. The aggregate demand curve is in fact downward sloping as a result of three distinct effects; Pigou's wealth effect
Pigou effect
The Pigou effect is an economics term that refers to the stimulation of output and employment caused by increasing consumption due to a rise in real balances of wealth, particularly during deflation....

, the Keynes' interest rate effect
Keynes effect
The Keynes effect is a term used in economics to describe a situation where a change in interest rates affects expenditure more than it affects savings.As prices fall, a given nominal amount of money will become a larger real amount...

 and the Mundell-Fleming exchange-rate effect.

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.

where
  • is consumption (may also be known as consumer spending) = ,
  • is Investment,
  • is Government spending,
  • is Net export,
    • is total exports, and
    • is total imports = .


These four major parts, which 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
    Consumption function
    In economics, the consumption function is a single mathematical function used to express consumer spending. It was developed by John Maynard Keynes and detailed most famously in his book The General Theory of Employment, Interest, and Money. The function is used to calculate the amount of total...

    . The consumption function is C= a + (mpc)(Y-T)
    • a is autonomous consumption, mpc is the marginal propensity to consume
      Marginal propensity to consume
      In economics, the marginal propensity to consume is an empirical metric that quantifies induced consumption, the concept that the increase in personal consumer spending occurs with an increase in disposable income...

      , (Y-T) is the disposable income.

  • gross
    Gross (economics)
    In economics, gross means before deductions. The antonym is net, meaning after deductions.-Usage:In this sense, it may appear an adjective, following the noun it modifies, e.g., "earned two million dollars, gross"...

     private domestic investment
    Investment
    Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...

     (I), such as spending by business firms on factory
    Factory
    A factory or manufacturing plant is an industrial building where laborers manufacture goods or supervise machines processing one product into another. Most modern factories have large warehouses or warehouse-like facilities that contain heavy equipment used for assembly line production...

     construction. This includes all private sector
    Private sector
    In economics, the private sector is that part of the economy, sometimes referred to as the citizen sector, which is run by private individuals or groups, usually as a means of enterprise for profit, and is not controlled by the state...

     spending aimed at 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
      National Income and Product Accounts
      The National Income and Product Accounts are part of the national accounts of the United States. They are produced by the Bureau of Economic Analysis of the Department of Commerce...

      , 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
      Interest rate
      An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...

       (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, an increase in the interest rate will cause aggregate demand to decline. Interest costs are part of the cost of borrowing and as they rise, both firms and households will cut back on spending. This shifts the aggregate demand curve to the left. This lowers equilibrium GDP below potential GDP. As production falls for many firms, they begin to lay off workers, and unemployment rises. The declining demand also lowers the price level. The economy is in recession.

  • gross government
    Government
    Government refers to the legislators, administrators, and arbitrators in the administrative bureaucracy who control a state at a given time, and to the system of government by which they are organized...

     investment and consumption expenditures (G).
  • net
    Net worth
    In business, net worth is the total assets minus total outside liabilities of an individual or a company. For a company, this is called shareholders' preference and may be referred to as book value. Net worth is stated as at a particular year in time...

     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
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...

 terms.

Aggregate demand curves


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

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
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...

 diagram.
Thus, that we could refer to an "aggregate quantity demanded" (Yd = C + Ip + G + NX in real or inflation-corrected terms) at any given aggregate average price level (such as the GDP deflator
GDP deflator
In economics, the GDP deflator is a measure of the level of prices of all new, domestically produced, final goods and services in an economy...

), P.

In these diagrams, typically the Yd rises as the average price level (P) falls, as with the AD line in the diagram. The main theoretical reason for this is that if the nominal money
Money
Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...

 supply (Ms) is constant, a falling P implies that the real money supply (Ms/P)rises, encouraging lower interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...

s and higher spending. This is often called the "Keynes effect
Keynes effect
The Keynes effect is a term used in economics to describe a situation where a change in interest rates affects expenditure more than it affects savings.As prices fall, a given nominal amount of money will become a larger real amount...

."

Carefully using ideas from the theory
Theory
The English word theory was derived from a technical term in Ancient Greek philosophy. The word theoria, , meant "a looking at, viewing, beholding", and referring to contemplation or speculation, as opposed to action...

 of supply and demand
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...

, aggregate supply
Aggregate supply
In economics, aggregate supply is the total supply of goods and services that firms in a national economy plan on selling during a specific time period...

 can help determine the extent to which increases in aggregate demand lead to increases in real output
Output (economics)
Output in economics is the "quantity of goods or services produced in a given time period, by a firm, industry, or country," whether consumed or used for further production.The concept of national output is absolutely essential in the field of macroeconomics...

 or instead to increases in prices (inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

). In the diagram, an increase in any of the components of AD (at any given P) shifts the AD curve to the right. This increases both the level of real production (Y) and the average price level (P).

But different levels of economic activity imply different mixtures of output and price increases. As shown, with very low levels of real gross domestic product
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....

 and thus large amounts of unemployed resources, most economists of the Keynesian school
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...

 suggest that most of the change would be in the form of output and employment increases. As the economy gets close to potential output
Potential output
In economics, potential output refers to the highest level of real Gross Domestic Product output that can be sustained over the long term. The existence of a limit is due to natural and institutional constraints...

 (Y*), we would see more and more price increases rather than output increases as AD increases.

Beyond Y*, this gets more intense, so that price increases dominate. Worse, output levels greater than Y* cannot be sustained for long. The AS is a short-term relationship here. If the economy persists in operating above potential, the AS curve will shift to the left, making the increases in real output transitory.

At low levels of Y, the world is more complicated. First, most modern industrial economies experience few if any falls in prices. So the AS curve is unlikely to shift down or to the right. Second, when they do suffer price cuts (as in Japan), it can lead to disastrous deflation
Deflation (economics)
In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% . This should not be confused with disinflation, a slow-down in the inflation rate...

.

Marxian critique



In Marxian economics
Marxian economics
Marxian economics refers to economic theories on the functioning of capitalism based on the works of Karl Marx. Adherents of Marxian economics, particularly in academia, distinguish it from Marxism as a political ideology and sociological theory, arguing that Marx's approach to understanding the...

, the equation of aggregate demand with expenditure on GDP or GNP is rejected as false, on conceptual and statistical grounds.

First, GDP as a measure of value added
Value added
In economics, the difference between the sale price and the production cost of a product is the value added per unit. Summing value added per unit over all units sold is total value added. Total value added is equivalent to Revenue less Outside Purchases...

 excludes purchases of all intermediate goods and services
Intermediate consumption
Intermediate consumption is an economic concept used in national accounts, such as the United Nations System of National Accounts , the US National Income and Product Accounts and the European System of Accounts .Conceptually, the aggregate "intermediate consumption" is equal to the amount of the...

 used up in production. Even so, gross value added cannot be simply equated with final demand, insofar as it excludes transfers, property income and most trade in second-hand items.

Second, Gross Output
Gross Output
Gross output is an economic concept used in national accounts such as the United Nations System of National Accounts and the US National Income and Product Accounts...

 from which GDP is derived by deducting intermediate expenditures, encompasses only those flows of income or expenditure regarded as related to production. Property income in the form of certain types of interest, transfers, land rents and realised capital gains from asset sales are excluded from gross output and GDP. Therefore, if the amount of property income (or transfers) increases, although GDP remains constant, national income receipts can nevertheless increase, and consequently aggregate demand can also increase.

Third, gross fixed capital formation
Gross fixed capital formation
Gross fixed capital formation is a macroeconomic concept used in official national accounts such as the UNSNA, NIPAs and the European System of Accounts . The concept dates back to the NBER studies of Simon Kuznets of capital formation in the 1930s, and standard measures for it were adopted in the...

 measures only investment in productive fixed assets and real estate, and does not constitute total investment, which includes also purchases of financial assets.

Fourth, GDP in principle excludes sales of second-hand assets except for those modified by some prior productive activity (e.g. reconditioned cars).

Finally, expenditure on GDP obviously disregards the creation of credit money by banks and governments, which boosts aggregate demand.

Thus, it is argued, the catch-all Keynesian notion of aggregate demand:
  • obscures the distribution of income between social classes with different propensities to save, consume and invest, and
  • fails to differentiate appropriately between different kinds of investment and consumption expenditure.


Restraining consumption and a higher savings rate does not automatically imply more investment, and lower investment does not automatically mean higher consumption expenditure. Funds may (as Keynes himself acknowledges) be hoarded.

Debt


A Post-Keynesian theory of aggregate demand emphasizes the role of debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...

, which it considers a fundamental component of aggregate demand; the contribution of change in debt to aggregate demand is referred to by some as the . Aggregate demand is spending, be it on consumption, investment, or other categories. Spending is related to income via:
Income – Spending = Net Savings

Rearranging this yields:
Spending = Income + Net Change in Debt

In words: what you spend is what you earn, plus what you borrow: if you spend $110 and earned $100, then you must have net borrowed $10; conversely if you spend $90 and earn $100, then you have net savings of $10, or have reduced debt by $10, for net change in debt of –$10.

If debt grows or shrinks slowly as a percentage of GDP, its impact on aggregate demand is small; conversely, if debt is significant, then changes in the dynamics of debt growth can have significant impact on aggregate demand. Change in debt is tied to the level of debt: if the overall debt level is 10% of GDP and 1% of loans are not repaid, this impacts GDP by 1% of 10% = 0.1% of GDP, which is statistical noise. Conversely, if the debt level is 300% of GDP and 1% of loans are not repaid, this impacts GDP by 1% of 300% = 3% of GDP, which is significant: a change of this magnitude will generally cause a recession
Recession
In economics, a recession is a business cycle contraction, a general slowdown in economic activity. During recessions, many macroeconomic indicators vary in a similar way...

. Similarly, changes in the repayment rate (debtors paying down their debts) impact aggregate demand in proportion to the level of debt. Thus, as the level of debt in an economy grows, the economy becomes more sensitive to debt dynamics, and credit bubbles are of macroeconomic concern. Since write-offs and savings rates both spike in recessions, both of which result in shrinkage of credit, the resulting drop in aggregate demand can worsen and perpetuate the recession in a vicious cycle.

This perspective originates in, and is intimately tied to, the debt-deflation theory of Irving Fisher
Irving Fisher
Irving Fisher was an American economist, inventor, and health campaigner, and one of the earliest American neoclassical economists, though his later work on debt deflation often regarded as belonging instead to the Post-Keynesian school.Fisher made important contributions to utility theory and...

, and the notion of a credit bubble (credit being the flip side of debt), and has been elaborated in the Post-Keynesian school. If the overall level of debt is rising each year, then aggregate demand exceeds Income by that amount. However, if the level of debt stops rising and instead starts falling (if "the bubble bursts"), then aggregate demand falls short of income, by the amount of net savings (largely in the form of debt repayment or debt writing off, such as in bankruptcy). This causes a sudden and sustained drop in aggregate demand, and this shock is argued to be the proximate cause of a class of economic crises, properly financial crises. Indeed, a fall in the level of debt is not necessary – even a slowing in the rate of debt growth causes a drop in aggregate demand (relative to the higher borrowing year). These crises then end when credit starts growing again, either because most or all debts have been repaid or written off, or for other reasons as below.

From the perspective of debt, the Keynesian prescription of government deficit spending
Deficit spending
Deficit spending is the amount by which a government, private company, or individual's spending exceeds income over a particular period of time, also called simply "deficit," or "budget deficit," the opposite of budget surplus....

 in the face of an economic crisis consists of the government net dis-saving (increasing its debt) to compensate for the shortfall in private debt: it replaces private debt with public debt. Other alternatives include seeking to restart the growth of private debt ("reflate the bubble"), or slow or stop its fall; and debt relief
Debt relief
Debt relief is the partial or total forgiveness of debt, or the slowing or stopping of debt growth, owed by individuals, corporations, or nations. From antiquity through the 19th century, it refers to domestic debts, in particular agricultural debts and freeing of debt slaves...

, which by lowering or eliminating debt stops credit from contracting (as it cannot fall below zero) and allows debt to either stabilize or grow – this has the further effect of redistributing wealth from creditors (who write off debts) to debtors (whose debts are relieved).

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