Aggregate demand

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This article is about a concept in macroeconomics. For the microeconomic demand
aggregated over consumers, see Demand curve.
In macroeconomics, aggregate demand (AD) or domestic final demand (DFD) is the
total demand for final goods and services in an economy at a given time.[1] It
specifies the amounts of goods and services that will be purchased at all possible
price levels.[2] This is the demand for the gross domestic product of a country. It
is often called effective demand, though at other times this term is distinguished.

The aggregate demand curve is plotted with real output on the horizontal axis and
the price level on the vertical axis. It is downward sloping as a result of three
distinct effects: Pigou's wealth effect, Keynes' interest rate effect and the
MundellFleming exchange-rate effect. The Pigou effect states that a higher price
level implies lower real wealth and therefore lower consumption spending, giving a
lower quantity of goods demanded in the aggregate. The Keynes effect states that a
higher price level implies a lower real money supply and therefore higher interest
rates resulting from financial market equilibrium, in turn resulting in lower
investment spending on new physical capital and hence a lower quantity of goods
being demanded in the aggregate.

The MundellFleming exchange-rate effect is an extension of the ISLM model.

Whereas the traditional IS-LM Model deals with a closed economy, MundellFleming
describes a small open economy. The MundellFleming model portrays the short-run
relationship between an economy's nominal exchange rate, interest rate, and output
(in contrast to the closed-economy ISLM model, which focuses only on the
relationship between the interest rate and output)

The aggregate demand curve illustrates the relationship between two factors: the
quantity of output that is demanded and the aggregate price level. Aggregate demand
is expressed contingent upon a fixed level of the nominal money supply. There are
many factors that can shift the AD curve. Rightward shifts result from increases in
the money supply, in government expenditure, or in autonomous components of
investment or consumption spending, or from decreases in taxes.

According to the aggregate demand-aggregate supply model, when aggregate demand

increases, there is movement up along the aggregate supply curve, giving a higher
level of prices.[3]

Contents [hide]
1 History
2 Components
3 Aggregate demand curves
3.1 Keynesian cross
3.2 Aggregate demand-aggregate supply model
4 Debt
5 Criticisms
6 See also
7 References
8 External links
History[edit]
Main article: The General Theory of Employment, Interest and Money
John Maynard Keynes in The General Theory of Employment, Interest and Money argued
during the Great Depression that the loss of output by the private sector as a
result of a systemic shock (the Wall Street Crash of 1929) ought to be filled by
government spending. First, he argued that with a lower effective aggregate
demand, or the total amount of spending in the economy (lowered in the Crash), the
private sector could subsist on a permanently reduced level of activity and
involuntary unemployment, unless there were active intervention. Business lost
access to capital, so it had dismissed workers. This meant workers had less to
spend as consumers, consumers bought less from business, which because of
additionally reduced demand, had found the need to dismiss workers. The downward
spiral could only be halted and rectified by external action. Second, people with
higher incomes have a lower marginal propensity to consume their incomes. People
with lower incomes are inclined to spend their earnings immediately to buy housing,
food, transport and so forth, while people with much higher incomes cannot consume
everything. They save instead, which means that the velocity of money, meaning the
circulation of income through different hands in the economy, is decreased. This
lowered the rate of growth. Spending should therefore target public works
programmes on a large enough scale to speed up growth to its previous levels.

Components[edit]
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:[4]

{\displaystyle AD=C+I+G+(X-M)} AD=C+I+G+(X-M)

where

{\displaystyle C} C is consumption (may also be known as consumer spending), which

is given by {\displaystyle a_{c}+b_{c}(Y-T)} a_{c}+b_{c}(Y-T) where {\displaystyle
Y} Y is consumers' income and {\displaystyle T} T the taxes paid by consumers,
{\displaystyle I} I is investment,
{\displaystyle G} G is government spending,
{\displaystyle NX=X-M} NX=X-M is net exports, where
{\displaystyle X} X is total exports, and
{\displaystyle M} M total imports, given by {\displaystyle a_{m}+b_{m}(Y-T)} a_{m}
+b_{m}(Y-T).
These four major parts, which can be stated in either 'nominal' or 'real' terms,
are:

personal consumption expenditures ( {\displaystyle C} C) or "consumption," demand

by households and unattached individuals; its determination is described by the
consumption function. A basic conception is that it is the total consumption
expenditures of the domestic economy. The consumption function is {\displaystyle
C=a+MPC\times (Y-T)} C=a+MPC\times (Y-T), where
{\displaystyle a} a is autonomous consumption, {\displaystyle MPC} MPC the marginal
propensity to consume, and {\displaystyle (Y-T)} (Y-T) the disposable income.
gross private domestic investment ( {\displaystyle I} I), such as spending by
business firms on factory construction. This is conceived as all private sector
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, it is
treated as a purchase by its producer.) Thus, only the planned or intended or
desired part of investment ( {\displaystyle I_{p}} I_p) is counted as part of
aggregate demand. (So, {\displaystyle I} I does not include the 'investment' in
running up or depleting inventory levels.)
Investment is affected by the output and the interest rate ( {\displaystyle i} i).
Consequently, we can write it as, {\displaystyle I(Y,i)} I(Y,i), a function I which
takes total income and interest rate as parameters. Investment has positive
relationship with the output and negative relationship with the interest rate.
Thus, 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.
gross government investment and consumption expenditures ( {\displaystyle G} G),
also determined as {\displaystyle G-T} {\displaystyle G-T}, the difference of
government expenditures and taxes. An increase in government expenditures or
decrease in taxes, therefore leads to an increase in GDP as government expenditures
are a component of aggregate demand.
net exports ( {\displaystyle NX} NX and sometimes ( {\displaystyle X-M} X-M)), net
demand by the rest of the world for the country's output. This contributes to the
current account.
In sum, for a single country at a given time, aggregate demand ( {\displaystyle D}
D or {\displaystyle AD} AD) is given by {\displaystyle C+I_{p}+G+(X-M)} C+I_{p}+G+
(X-M).

These macroeconomic variables are constructed from varying types of microeconomic

variables from the price of each, so these variables are denominated in (real or
nominal) currency terms.

Aggregate demand curves[edit]

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[edit]
Main article: Keynesian cross
Aggregate demand-aggregate supply model[edit]
Main article: ADAS 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.

Aggregate supply/demand graph

Thus, we could refer to an "aggregate quantity demanded" ( {\displaystyle
Y^{d}=C+I_{p}+G+NX} Y^{d}=C+I_{p}+G+NX in real or inflation-corrected terms) at any
given aggregate average price level (such as the GDP deflator), {\displaystyle P}
P.

In these diagrams, typically the {\displaystyle Y^{d}} Y^{d} rises as the average
price level ( {\displaystyle P} P) falls, as with the {\displaystyle AD} AD line in
the diagram. The main theoretical reason for this is that if the nominal money
supply (Ms) is constant, a falling {\displaystyle P} P implies that the real money
supply ( {\displaystyle {\frac {M^{s}}{P}}} {\frac {M^{s}}{P}})rises, encouraging
lower interest rates and higher spending. This is often called the "Keynes effect."

Carefully using ideas from the theory of supply and demand, aggregate supply can
help determine the extent to which increases in aggregate demand lead to increases
in real output or instead to increases in prices (inflation). In the diagram, an
increase in any of the components of {\displaystyle AD} AD (at any given
{\displaystyle P} P) shifts the {\displaystyle AD} AD curve to the right. This
increases both the level of real production ( {\displaystyle Y} Y) and the average
price level ( {\displaystyle P} 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 and
thus large amounts of unemployed resources, most economists of the Keynesian school
suggest that most of the change would be in the form of output and employment
increases. As the economy gets close to potential output ( {\displaystyle Y^{*}}
Y^{*}), we would see more and more price increases rather than output increases as
{\displaystyle AD} AD increases.
Beyond {\displaystyle Y^{*}} Y^{*}, this gets more intense, so that price increases
dominate. Worse, output levels greater than {\displaystyle Y^{*}} Y^{*} cannot be
sustained for long. The {\displaystyle AS} AS is a short-term relationship here. If
the economy persists in operating above potential, the {\displaystyle AS} AS curve
will shift to the left, making the increases in real output transitory.

At low levels of {\displaystyle Y} Y, the world is more complicated. First, most

modern industrial economies experience few if any falls in prices. So the
{\displaystyle AS} 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.

Debt[edit]
A post-Keynesian theory of aggregate demand emphasizes the role of debt, which it
considers a fundamental component of aggregate demand;[5] the contribution of
change in debt to aggregate demand is referred to by some as the credit impulse.[6]
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 Savings = Income + Net Increase 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 a
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:[5] 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.

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, and the notion of a credit bubble (credit being the flip
side of debt), and has been elaborated in the Post-Keynesian school.[5] 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).[7] 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 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, 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).

Criticisms[edit]
Austrian theorist Henry Hazlitt argued that aggregate demand is "a meaningless
concept" in economic analysis.[8] Friedrich Hayek, another Austrian, wrote that
Keynes' study of the aggregate relations in an economy is "fallacious," arguing
that recessions are caused by micro-economic factors.[9]

See also[edit]
Aggregate supply
Aggregation problem
Disequilibrium
Economic surplus
Effective demand
Excess demand
Excess demand function
Excess supply
Induced demand
Reproduction
Scarcity
Supply and demand
Supply shock
References[edit]
Jump up ^ Sexton, Robert; Fortura, Peter (2005). Exploring Economics. ISBN 0-17-
641482-7. This is the sum of the demand for all final goods and services in the
economy. It can also be seen as the quantity of real GDP demanded at different
price levels.
Jump up ^ O'Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in
action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. p. 307. ISBN
0-13-063085-3.
Jump up ^ Mankiw, N. Gregory, and William M. Scarth. Macroeconomics. Canadian ed.,
4th ed. New York: Worth Publishers, 2011. Print.
Jump up ^ "aggregate demand (AD)". Archived from the original on 9 November 2007.
Retrieved 2007-11-04.
^ Jump up to: a b c Debtwatch No 41, December 2009: 4 Years of Calling the GFC,
Steve Keen, December 1, 2009
Jump up ^ Credit and Economic Recovery: Demystifying Phoenix Miracles, Michael
Biggs, Thomas Mayer, Andreas Pick, March 15, 2010
Jump up ^ "However much you borrow and spend this year, if it is less than last
year, it means your spending will go into recession." Dhaval Joshi, RAB Capital,
quoted in Noughty boys on trading floor led us into debt-laden fantasy
Jump up ^ Hazlitt, Henry (1959). The Failure of the 'New Economics': An Analysis of
the Keynesian Fallacies (PDF). D. Van Nostrand.[page needed]
Jump up ^ Hayek, Friedrich (1989). The Collected Works of F.A. Hayek. University of
Chicago Press. p. 202. ISBN 978-0-226-32097-7.
External links[edit]
Elmer G. Wiens: Classical & Keynesian AD-AS Model - An on-line, interactive model
of the Canadian Economy.
[show] v t e
Economics
Categories: DemandMacroeconomic aggregatesMathematical and quantitative methods
(economics)
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