Introduction

What Is Aggregate Demand? Aggregate demand is a measurement of the

total amount of demand for all finished goods and services produced in an
economy. Aggregate demand is expressed as the total amount of money
exchanged for those goods and services at a specific price level and point in
time.
KEY TAKEAWAYS

 Aggregate demand measures the total amount of demand for all finished
goods and services produced in an economy.
 Aggregate demand is expressed as the total amount of money spent on
those goods and services at a specific price level and point in time.
 Aggregate demand consists of all consumer goods, capital goods
(factories and equipment), exports, imports, and government spending.
Understanding Aggregate Demand
Aggregate demand is a macroeconomic term that represents the total demand for
goods and services at any given price level in a given period. Aggregate demand over
the long term equals gross domestic product (GDP) because the two metrics are
calculated in the same way. GDP represents the total amount of goods and
services produced in an economy while aggregate demand is the demand or desire for
those goods. As a result of the same calculation methods, the aggregate demand and
GDP increase or decrease together.

Technically speaking, aggregate demand only equals GDP in the long run
after adjusting for the price level. This is because short-run aggregate
demand measures total output for a single nominal price level whereby
nominal is not adjusted for inflation. Other variations in calculations can occur
depending on the methodologies used and the various components.

Aggregate demand consists of all consumer goods, capital goods (factories

and equipment), exports, imports, and government spending programs. The
variables are all considered equal as long as they trade at the same market
value.
Aggregate Demand Curve
If you were to represent aggregate demand graphically, the aggregate amount of goods and
services demanded would be placed on the horizontal X-axis, and the overall price level of the
entire basket of goods and services would be represented on the vertical Y-axis.

The aggregate demand curve, like most typical demand curves, slopes downward from left to
right. Demand increases or decreases along the curve as prices for goods and services either
increase or decrease. Also, the curve can shift due to changes in the money supply, or increases
and decreases in tax rates.

Calculating Aggregate Demand

The equation for aggregate demand adds the amount of consumer spending, private investment,
government spending, and the net of exports and imports. The formula is shown as follows:

\begin{aligned} &\text{Aggregate Demand} = \text{C} + \text{I} + \

text{G} + \text{Nx} \\ &\textbf{where:}\\ &\text{C} = \text{Consumer
spending on goods and services} \\ &\text{I} = \text{Private investment
and corporate spending on} \\ &\text{non-final capital goods (factories,
equipment, etc.)} \\ &\text{G} = \text{Government spending on public
goods and social} \\ &\text{services (infrastructure, Medicare, etc.)} \\
&\text{Nx} = \text{Net exports (exports minus imports)} \\ \end{aligned}
Aggregate Demand=C+I+G+Nxwhere:C=Consumer spending on 
goods and servicesI=Private investment and corporate spendin
g onnon-final capital goods (factories, equipment, 
etc.)G=Government spending on public goods and socialservice
s (infrastructure, Medicare, etc.)Nx=Net exports (exports minus 
imports)

Factors That Influence Aggregate Demand

A variety of economic factors can affect the aggregate demand in an economy. Key
ones include:

 Interest Rates: Whether interest rates are rising or falling will affect decisions made

by consumers and businesses. Lower interest rates will lower the borrowing costs for
big-ticket items such as appliances, vehicles, and homes. Also, companies will be able
to borrow at lower rates, which tends to lead to capital spending increases. Conversely,
higher interest rates increase the cost of borrowing for consumers and companies. As a
result, spending tends to decline or grow at a slower pace, depending on the extent of
the increase in rates.
  Income and Wealth: As household wealth increases, aggregate demand usually
increases as well. Conversely, a decline in wealth usually leads to lower aggregate
demand. Increases in personal savings will also lead to less demand for goods, which
tends to occur during recessions. When consumers are feeling good about the
economy, they tend to spend more leading to a decline in savings.
 Inflation Expectations: Consumers who feel that inflation will increase or prices will
rise, tend to make purchases now, which leads to rising aggregate demand. But if
consumers believe prices will fall in the future, aggregate demand tends to fall as well.
 Currency Exchange Rates: If the value of the U.S. dollar falls (or rises), foreign goods
will become more (or less expensive). Meanwhile, goods manufactured in the U.S. will
become cheaper (or more expensive) for foreign markets. Aggregate demand will,
therefore, increase (or decrease). 

What Are Some Limitations of Aggregate Demand?

While aggregate demand is helpful in determining the overall strength of
consumers and businesses in an economy, it does pose some limitations. Since
aggregate demand is measured by market values, it only represents total output
at a given price level and does not necessarily represent quality or standard of
living. Also, aggregate demand measures many different economic transactions
between millions of individuals and for different purposes. As a result, it can
become challenging when trying to determine the causes of demand for
analytical purposes
  Interactions Between Goods and Money Markets:

 By Goods Market, we mean all the buying and selling of goods and services.

 By Money Market, we mean the interaction between demand for money and the supply of money (the
size of the money stock) as set by the Federal Reserve working through the banking system.

Now, once you have the goods market and money market firmly in mind, we can proceed to examine
the interactions between the two.

 Caution: Never use the word money for income or savings or investment, and never use the

word investment to describe the purchase of stocks, bonds and financial assets. We need to
be very  careful with terminology because we want to carefully distinguish between what is
happening in the goods markets (which describes a flow equilibrium between the production
and purchase of real goods and services in a given year) and the money market (which describes
a stock equilibrium between the demand and supply of money holdings and financial assets at a
given point in time). The secret to doing well in this material is using words very carefully.

 The interactions are very straightforward:

 A. The money market determines the interest rate. The demand for money in the money market is
affected by income (which is determined in the goods market).
 B. The goods market determines income, which depends on planned investment. Planned investment in
turn depends on the interest rate (which is determined in the money market).

 Thus:

If something changes in goods markets and affects Y, this in turn will affect Md and hence affect r.

 If something changes in money markets and affects r, this in turn will affect Ip, and hence affect Y.

  The Interest Rate and Planned Investment:

 Back when we first set out the goods market, we had to leave Ip as fixed -- exogenously set. Now,
finally, we have a theory about why Ip might change.

 The argument is as follows: interest rates reflect the cost of borrowing in order to finance investment
projects. (Interest rates are not the only thing that determines decisions, but they are the variable we
will focus on since they give us the links between the money market and the goods market). Other
things being equal, as interest rates rise, it becomes more expensive to finance investment projects.
Thus, as r increases, the number of investment projects planned will decline. This will reduce the level of
investment expenditures in the goods market.

 So Ip increases as r decreases, and Ip decreases as r increases.

 A more extensive explanation would go like this: a firm may have a number of different capital
investment projects in mind. If we assume that it can consider each one separately, and attach an
expected rate of return to it with confidence, then at an interest rate of ten percent a firm will
undertake all the projects that will generate a ten percent rate of return or better, but it will not borrow
at ten percent to finance a project that will produce only a nine percent return. If the interest rate falls
to eight percent, though, that project that offered a nine percent return now looks pretty good. So the
lower the interest rate, the larger the amount of capital equipment firms will acquire, or the higher will
be Ip.

Planned Investment and the Equilibrium Level of National Income:

 As shown above, as r decreases, Ip increases. Now as Ip increases, aggregate expenditures increase.
And, as aggregate expenditures increase, equilibrium Y increases.

 This works exactly like an increase in G: it's additional demand for goods, which will call forth additional
output of goods. As output (Y) rises C rises, which means even more demand for goods, more output,
more C, etcetera. So the multiplier process will produce a larger change in equilibrium Y than the initial
increment in Ip.

 So we have the whole picture in place. When the Fed increases the money supply, it lowers the interest
rate. This causes Ip to increase, and thus causes aggregate expenditures to increase. This in turn will set
loose our multiplier and cause income to increase.

 When the Fed reduces the money supply, this causes interest rates to rise, this in turn causes Ip to fall,
and thus causes aggregate expenditures to fall. This is turn will let loose our multiplier process and cause
income and employment to decrease.

 Thus, expansionary monetary policy means that the Fed is either reducing the required reserve ratio,
lowering the discount rate, or buying bonds. Any of these policies will increase the money supply, which
 should reduce interest rates and cause investment, and hence expenditures, and income and
employment, to increase.

 Contractionary monetary policy is when the Fed practices a policy of "tight money." This involves either
raising the required reserve ratio, raising the discount rate, or selling bonds. Any of these policies will
reduce the money supply (hence "tight money"), which will increase the interest rate. This causes
investment to fall, which in turn will cause expenditures, income and employment to decrease.

Impact of the Goods Market on the Money Market:

 We're not quite done yet.

 We've have looked at how the money markets affect the goods markets, but not examined the reverse
in any detail.

 The argument is: as Y increases, Md increases. As Md increases, ceteris paribus,  r will increase.

 Let us say that the government cut taxes. This will cause Y to increase. As Y increased in the goods
market. Md increases, causing r to increase. As a result, Ip will fall.

 Similarly if Y falls, Md falls. As Md falls, ceteris paribus,  r will fall.

 On the other hand if government spending were cut, the resulting lower Y would reduce Md, and r
would fall. Ip would then rise.

 (We also noted earlier that if the price level changed Md would change. We'll get to price-level changes
later.)

Characteristics of Money Market

 Short-term Funds. It is a market purely for short-term funds or financial assets called near money.
 Maturity Period. ...
 Conversion of Cash. ...
 No Formal Place. ...
 Sub-markets. ...
 Role of Market. ...
 Highly Organized Banking System. ...
 Existence of Secondary Market.