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 commonly 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, exports, imports, and
government spending.

Understanding Aggregate Demand

Aggregate demand is a macroeconomic term and can be compared with the gross domestic
product (GDP). GDP represents the total amount of goods and services produced in an economy
while aggregate demand is the demand or desire for those goods. Aggregate demand and
GDP commonly increase or decrease together.

Aggregate demand equals GDP only in the long run after adjusting for the price level. Short-run
aggregate demand measures total output for a single nominal price level without adjusting 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, exports, imports, and
government spending programs. All variables are considered equal if they trade at the same
market value.

While aggregate demand helps determine the overall strength of consumers and businesses in an
economy, it does have limits. Since aggregate demand is measured by market values, it only
represents total output at a given price level and does not necessarily represent the quality of life
or standard of living in a society.

Aggregate Demand Components

Aggregate demand is determined by the overall collective spending on products and services by
all economic sectors on the procurement of goods and services by four components:

Consumption Spending
Consumer spending represents the demand by individuals and households within the economy.
While there are several factors in determining consumer demand, the most important is consumer
incomes and the level of taxation.

Investment Spending

Investment spending represents businesses' investment to support current output and increase
production capability. It may include spending on new capital assets such as equipment,
facilities, and raw materials.

Government Spending

Government spending represents the demand produced by government programs, such as

infrastructure spending and public goods. This does not include services such as Medicare or
social security, because these programs simply transfer demand from one group to another.

Net Exports

Net exports represent the demand for foreign goods, as well as the foreign demand for domestic
goods. It is calculated by subtracting the total value of a country's exports from the total value of
all imports.

Aggregate Demand Formula

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

Aggregate Demand=C+I+G+Nx

where:C=Consumer spending on goods and servicesI=Private investment and co

rporate spending onnon-final capital goods (factories, equipment, etc.)G=Gover
nment spending on public goods and socialservices (infrastructure, Medicare, et
c.)Nx=Net exports (exports minus imports)Aggregate Demand=C+I+G+N
xwhere:C=Consumer spending on goods and servicesI=Private investment and
corporate spending onnon-final capital goods (factories, equipment, etc.)G=Gov
ernment spending on public goods and socialservices (infrastructure, Medicare,
etc.)Nx=Net exports (exports minus imports)
The aggregate demand formula above is also used by the Bureau of Economic Analysis to
measure GDP in the U.S.1

Aggregate Demand Curve

Like most typical demand curves, it slopes downward from left to right with goods and services
on the horizontal X-axis and the overall price level of the basket of goods and services on the
vertical Y-axis. Demand increases or decreases along the curve as prices for goods and services
either increase or decrease.

What Affects Aggregate Demand?

Interest Rates

Interest rates 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 and companies
will be able to borrow at lower rates, often leading to capital spending increases. Higher interest
rates increase the cost of borrowing for consumers and companies and spending tends to decline
or grow at a slower pace.

Income and Wealth

As household wealth increases, aggregate demand typically increases. Conversely, a decline in

wealth usually leads to lower aggregate demand. When consumers are feeling good about the
economy, they tend to spend more and save less.

Inflation Expectations

Consumers who anticipate that inflation will increase or prices will rise tend to make immediate
purchases leading to rises in aggregate demand. But if consumers believe prices will fall in the
future, aggregate demand typically falls.

Currency Exchange Rates

When the value of the U.S. dollar falls, foreign goods will become more expensive. Meanwhile,
goods manufactured in the U.S. will become cheaper for foreign markets. Aggregate demand
will, therefore, increase. When the value of the dollar increases, foreign goods are cheaper and
U.S. goods become more expensive to foreign markets, and aggregate demand decreases.

Economic Conditions and Aggregate Demand

Economic conditions can impact aggregate demand whether those conditions originated
domestically or internationally. The financial crisis of 2007-08, sparked by massive amounts of
mortgage loan defaults, and the ensuing Great Recession, offer a good example of a decline in
aggregate demand due to economic conditions.

With businesses suffering from less access to capital and fewer sales, they began to lay off
workers and GDP growth contracted in 2008 and 2009, resulting in a total production contraction
in the economy during that period. A poor-performing economy and rising unemployment led to
a decline in personal consumption or consumer spending. Personal savings also surged as
consumers held onto cash due to an uncertain future and instability in the banking system.

In 2020, the COVID-19 pandemic caused reductions in both aggregate supply or production, and
aggregate demand or spending. Social distancing measures and concerns about the spread of the
virus caused a significant decrease in consumer spending, particularly in services as many
businesses closed. These dynamics lowered aggregate demand in the economy. As aggregate
demand fell, businesses either laid off part of their workforces or otherwise slowed production as
employees contracted COVID-19 at high rates.2

Aggregate Demand vs. Aggregate Supply

In times of economic crises, economists often debate as to whether aggregate demand
slowed, leading to lower growth, or GDP contracted, leading to less aggregate demand. Whether
demand leads to growth or vice versa is economists' version of the age-old question of what
came first—the chicken or the egg.

Boosting aggregate demand also boosts the size of the economy regarding measured GDP.
However, this does not prove that an increase in aggregate demand creates economic growth.
Since GDP and aggregate demand share the same calculation, it only indicates that they increase
concurrently. The equation does not show which is the cause and which is the effect.

Early economic theories hypothesized that production is the source of demand. The 18th-century
French classical liberal economist Jean-Baptiste Say stated that consumption is limited to
productive capacity and that social demands are essentially limitless, a theory referred to as Say's
Law of Markets.3

Say's law, the basis of supply-side economics, ruled until the 1930s and the advent of the
theories of British economist John Maynard Keynes. By arguing that demand drives supply,
Keynes placed total demand in the driver's seat. Keynesian macroeconomists have since believed
that stimulating aggregate demand will increase real future output and the total level of output in
the economy is driven by the demand for goods and services and propelled by money spent on
those goods and services.

Keynes considered unemployment to be a byproduct of insufficient aggregate demand because

wage levels would not adjust downward fast enough to compensate for reduced spending. He
believed the government could spend money and increase aggregate demand until idle economic
resources, including laborers, were redeployed.

Other schools of thought, notably the Austrian School and real business cycle theorists stress
consumption is only possible after production. This means an increase in output drives an
increase in consumption, not the other way around. Any attempt to increase spending rather than
sustainable production only causes maldistribution of wealth or higher prices, or both.

As a demand-side economist, Keynes further argued that individuals could end up damaging
production by limiting current expenditures—by hoarding money, for example. Other
economists argue that hoarding can impact prices but does not necessarily change capital
accumulation, production, or future output. In other words, the effect of an individual's saving
money—more capital available for business—does not disappear on account of a lack of
spending.

What Factors Affect Aggregate Demand?

Aggregate demand can be impacted by a few key economic factors. Rising or falling interest
rates will affect decisions made by consumers and businesses. Rising household wealth increases
aggregate demand while a decline usually leads to lower aggregate demand. Consumers'
expectations of future inflation will also have a positive correlation with aggregate demand.
Finally, a decrease (or increase) in the value of the domestic currency will make foreign goods
costlier (or cheaper) while goods manufactured in the domestic country will become cheaper (or
costlier) leading to an increase (or decrease) in aggregate demand.

What Are Some Limitations of Aggregate Demand?

While aggregate demand helps determine 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.

What's the Relationship Between GDP and Aggregate

Demand?
GDP (gross domestic product) measures the size of an economy based on the monetary value of
all finished goods and services made within a country during a specified period. As such, GDP is
the aggregate supply. Aggregate demand represents the total demand for these goods and
services at any given price level during the specified period. Aggregate demand eventually
equals gross domestic product (GDP) because the two metrics are calculated in the same way. As
a result, aggregate demand and GDP increase or decrease together.

The Bottom Line

Aggregate demand is a concept of macroeconomics that represents the total demand within an
economy for all kinds of goods and services at a certain price point. In the long term, aggregate
demand is indistinguishable from GDP. However, aggregate demand is not a perfect metric and
it is the subject of debate among economists.
KEYNESIAN THEORY OF ECONOMICS

What Is Keynesian Economics?

The central tenet of this school of thought is that government intervention can
stabilize the economy
Just how important is money? Few would deny that it plays a key role in the
economy.
During the Great Depression of the 1930s, existing economic theory was unable
either to explain the causes of the severe worldwide economic collapse or to
provide an adequate public policy solution to jump-start production and
employment.
British economist John Maynard Keynes spearheaded a revolution in economic
thinking that overturned the then-prevailing idea that free markets would
automatically provide full employment—that is, that everyone who wanted a job
would have one as long as workers were flexible in their wage demands (see
box). The main plank of Keynes’s theory, which has come to bear his name, is
the assertion that aggregate demand—measured as the sum of spending by
households, businesses, and the government—is the most important driving
force in an economy. Keynes further asserted that free markets have no self-
balancing mechanisms that lead to full employment. Keynesian economists
justify government intervention through public policies that aim to achieve full
employment and price stability.
The revolutionary idea
Keynes argued that inadequate overall demand could lead to prolonged periods
of high unemployment. An economy’s output of goods and services is the sum
of four components: consumption, investment, government purchases, and net
exports (the difference between what a country sells to and buys from foreign
countries). Any increase in demand has to come from one of these four
components. But during a recession, strong forces often dampen demand as
spending goes down. For example, during economic downturns uncertainty
often erodes consumer confidence, causing them to reduce their spending,
especially on discretionary purchases like a house or a car. This reduction in
spending by consumers can result in less investment spending by businesses, as
firms respond to weakened demand for their products. This puts the task of
increasing output on the shoulders of the government. According to Keynesian
economics, state intervention is necessary to moderate the booms and busts in
economic activity, otherwise known as the business cycle.

There are three principal tenets in the Keynesian description of how the
economy works:
1. Aggregate Demand Influence:
  Keynes emphasized that economic decisions made by individuals and
businesses collectively determine the total demand in the economy,
known as aggregate demand. This includes decisions on consumption,
investment, government spending, and net exports.
 Sometimes, private sector decisions may lead to undesirable outcomes
for the economy as a whole. For instance, during an economic
downturn, consumers and businesses may become cautious and cut
back on spending, leading to a decrease in aggregate demand, which
can exacerbate the recession.
 In such situations, Keynes advocated for government intervention to
stimulate demand and boost economic activity. This could involve
policies like increasing government spending on infrastructure
projects or providing tax incentives to encourage consumer spending.
 For example, during the 2008 financial crisis, many governments
around the world implemented stimulus packages to increase
aggregate demand and counteract the effects of the recession.
2. Price and Wage Rigidity:
 Keynes argued that prices, including wages, do not adjust quickly to
changes in supply and demand in the short run. This rigidity can lead
to imbalances in markets, such as shortages or surpluses, particularly
in labor markets.
 For instance, during an economic downturn, firms may face reduced
demand for their products or services but find it difficult to lower
wages immediately due to factors like labor contracts, social norms,
or minimum wage laws. As a result, they may choose to lay off
workers instead of reducing wages, leading to unemployment.
 Similarly, in times of economic expansion, increased demand for
labor may lead to labor shortages, pushing up wages. However, firms
may be reluctant to increase wages quickly, leading to labor shortages
and potential inflationary pressures.
 Graphically, this can be illustrated by a downward sloping aggregate
demand curve intersecting with a relatively flat short-run aggregate
supply curve, indicating that changes in demand primarily affect
output and employment in the short run, rather than prices.
3. Short-run Effects:
 Keynesians believe that changes in aggregate demand have the most
significant short-term impact on real output and employment, rather
than on prices. This is particularly true when prices and wages are
slow to adjust.
 For example, if the government increases spending during a recession,
it directly boosts aggregate demand, leading to an increase in output
 and employment as firms increase production to meet the higher
demand.
 This short-run relationship between changes in aggregate demand and
real output is often represented graphically by a Keynesian cross
diagram or an aggregate demand/aggregate supply (AD/AS) diagram.
In these diagrams, an increase in aggregate demand shifts the
aggregate demand curve to the right, leading to an increase in real
GDP and employment in the short run, with little impact on prices.
 However, over the long run, prices and wages may eventually adjust,
leading to a movement along the short-run aggregate supply curve and
potentially affecting inflation rates.

In summary, Keynesian economics emphasizes the importance of aggregate

demand in driving short-term fluctuations in output and employment. It
underscores the role of government intervention in stabilizing the economy,
particularly during periods of recession or economic downturns, when private
sector decisions may lead to suboptimal outcomes for the economy as a whole.
Stabilizing the economy
No policy prescriptions follow from these three tenets alone. What distinguishes
Keynesians from other economists is their belief in activist policies to reduce the
amplitude of the business cycle, which they rank among the most important of
all economic problems.

Rather than seeing unbalanced government budgets as wrong, Keynes advocated

so-called countercyclical fiscal policies that act against the direction of the
business cycle. For example, Keynesian economists would advocate deficit
spending on labor-intensive infrastructure projects to stimulate employment and
stabilize wages during economic downturns. They would raise taxes to cool the
economy and prevent inflation when there is abundant demand-side growth.
Monetary policy could also be used to stimulate the economy—for example, by
reducing interest rates to encourage investment. The exception occurs during a
liquidity trap, when increases in the money stock fail to lower interest rates and,
therefore, do not boost output and employment.
Keynes argued that governments should solve problems in the short run rather
than wait for market forces to fix things over the long run, because, as he wrote,
“In the long run, we are all dead.” This does not mean that Keynesians advocate
adjusting policies every few months to keep the economy at full employment. In
fact, they believe that governments cannot know enough to fine-tune
successfully.
Keynesianism evolves
Even though his ideas were widely accepted while Keynes was alive, they were
also scrutinized and contested by several contemporary thinkers. Particularly
noteworthy were his arguments with the Austrian School of Economics, whose
adherents believed that recessions and booms are a part of the natural order and
that government intervention only worsens the recovery process.

Keynesian economics dominated economic theory and policy after World War II
until the 1970s, when many advanced economies suffered both inflation and
slow growth, a condition dubbed “stagflation.” Keynesian theory’s popularity
waned then because it had no appropriate policy response for stagflation.
Monetarist economists doubted the ability of governments to regulate the
business cycle with fiscal policy and argued that judicious use of monetary
policy (essentially controlling the supply of money to affect interest rates) could
alleviate the crisis (see “What Is Monetarism?” in the March 2014 F&D).
Members of the monetarist school also maintained that money can have an effect
on output in the short run but believed that in the long run, expansionary
monetary policy leads to inflation only. Keynesian economists largely adopted
these critiques, adding to the original theory a better integration of the short and
the long run and an understanding of the long-run neutrality of money—the idea
that a change in the stock of money affects only nominal variables in the
economy, such as prices and wages, and has no effect on real variables, like
employment and output.
Both Keynesians and monetarists came under scrutiny with the rise of the new
classical school during the mid-1970s. The new classical school asserted that
policymakers are ineffective because individual market participants can
anticipate the changes from a policy and act in advance to counteract them. A
new generation of Keynesians that arose in the 1970s and 1980s argued that
even though individuals can anticipate correctly, aggregate markets may not
clear instantaneously; therefore, fiscal policy can still be effective in the short
run.
The global financial crisis of 2007–08 caused a resurgence in Keynesian
thought. It was the theoretical underpinnings of economic policies in response to
the crisis by many governments, including in the United States and the United
Kingdom. As the global recession was unfurling in late 2008, Harvard professor
N. Gregory Mankiw wrote in the New York Times, “If you were going to turn to
only one economist to understand the problems facing the economy, there is
little doubt that the economist would be John Maynard Keynes. Although
Keynes died more than a half-century ago, his diagnosis of recessions and
depressions remains the foundation of modern macroeconomics. Keynes wrote,
‘Practical men, who believe themselves to be quite exempt from any intellectual
influence, are usually the slave of some defunct economist.’ In 2008, no defunct
economist is more prominent than Keynes himself.”
But the 2007–08 crisis also showed that Keynesian theory had to better include
the role of the financial system. Keynesian economists are rectifying that
omission by integrating the real and financial sectors of the economy.■