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Aggregate Demand Definition
Aggregate demand is a macroeconomic term which refers to the total demand or exchange for products at a particular time and at a stated price. It is the total amount of goods and services produced in an economy, and the total demand for each commodity. Aggregate demand does not measure the standard of living in a nation (unlike demand in microeconomics), but rather it focuses on the demand at a given period and price.
A Little More on What is Aggregate Demand
Aggregate demand is equivalent to the gross domestic product (GDP) of an economy as each focuses on the total demand for commodities at different price values. Both terms share the same market pattern and would move in the same position in terms of accounting. It is, however, important to note that the aggregate demand is only equivalent to the GDP in the long run as it is only at this point that it adjusts to the price level of commodities in the market. This is due to the fact that short-run production is primarily focused on getting equilibrium demand for a single price and not for potential market prices in the future. For simplicity, price value is said to be 1. There are also other errors involved in calculating aggregate demand as it isn’t specific and works with a general model even for distinct products.
As long as commodities are supplied and demanded at the same price level, they are said to be equals, even without considering whether they are corporate, consumer or national commodities.
Mathematical Solution for Aggregate Demand
In calculating aggregate demand, one must employ the method used for computing an economy’s GDP, which in this case is the Keynesian equation. Using this equation, we have that:
AD= C + I + Nx
Where; A = Aggregate Demand
C = Consumer spending on commodities
I = Personal Investments and corporate financing
G = Government spending (National budgets and the likes)
Nx = Net export (the remains after imports have been removed).
Explaining Aggregate Demand with Assumptions
In a graphical illustration or representation of aggregate demand, the total output (mostly known as “quantity” on curves) goes on the X-axis, and the Overall Price level of all commodities goes on the Y-axis. Since aggregate demand is a type of demand, the curve typically slopes downward from left to right, thus portraying the market demand in relation to price. Here, if the price of commodities were to increase to its highest, the curve would be at the top left, signifying that fewer purchases are made. When the price drops to its lowest, the curve reaches the far right, signifying that demand has increased much more than before. The curve is also affected by tax rates as more expenses reduce taxes.
Determinants of Aggregate Demand
Given below are some factors which influence aggregate demand:
- Foreign Exchange rate change: Foreign Exchange (also called Forex or Currency Exchange) affects the aggregate demand of an economy. For instance, if the Canadian dollar were to incur a drop, the value of imported goods will become costlier, while the price of products manufactured in the nation will become cheaper. The opposite happens if the CAD were to increase.
- Personal Income: It goes without saying that the richer a person gets, the more he’d want to satisfy his wants.
- Personal Opinions about Fluctuation: If a person who purchases air conditioners for $400 each believes that the price will increase to $450 each in the near future, he or she will try to purchase and store as much air conditioners as possible at the current rate of $400, and this causes an increase in aggregate demand. On the other hand, if that individual feels that the price would drop to $350 in the near future, he or she might choose to wait till that time, thus causing a drop in the aggregate demand.
- Shift in Real Interest rates: This mostly applies to capital goods. The real interest rate determines consumers behavior in making purchases. The higher the rate, the higher the cost of commodities, and the lower the demand. Also, the lower the rates, the lower the cost of commodities, and the higher the demand.
Controversies Surrounding Aggregate Demand
An increase in aggregate demand secures an increase in the GDP of an economy but doesn’t actually certify economic growth. Both concepts make use of the same equation, which is the Keynesian equation in this case, which analyses only the growth but discards the cause. In economics, knowing why something exists in an economy is vital, but this is nowhere to be found in the relationship between aggregate demand and GDP. This issue has raised up different controversies. According to 18th Century French economist, Jean-Baptiste Say, consumption is as a result of production, and it is mostly dependent on it. He goes on to propose what is known today as Say’s Law, a theory that states that social wants are limitless, and only held in check by what can be produced. For example, people with enough money to purchase 200 units of canned tunas will be forced to buy less if only 20 units are available. This realistic example shows that production is a barrier to want.
However, using the demand-and-supply model, one can see that Jean-Baptiste’s statement does not entirely hold. According to British economist John Maynard Keynes, supply is as a result of demand, as the more consumers place an order for a particular item, the more it would be produced. This theory came to be referred to as the Keynesian Theory, and it gathered a large number of followers. According to this theory, on the demand-side of economics, the demand for a product drives production as well as the money which consumers are willing to spend on that product. So if people are willing to pay $40 per can of tuna instead of $30, it is only natural to see large bulk of cans being tossed into the market daily.
Keynes also stated that unemployment in an economy is as a result of inefficient aggregate demand, as the more the demand for an item, the more workers will be needed in the production and distribution of that particular item. He further proposed that government spending could influence employment by creating infrastructures that would allow displaced workers and resources to be redeployed.
These two theorists have gained a huge following, with the Austrian School and real business cycle adhering to the teachings of Say’s Law. They argue that consumption is only possible after production, stating that an increase in production stirs an increase in consumption and not the other way around. They further imply that increasing spending rather than production will cause a shift in prices and would be deemed a misuse of wealth.
Followers of Keynes Theory, however, believe that the consumers can lay waste to products that are manufactured by deciding to hoard their wealth and not make purchases. Another school of thoughts, however, believe that this wouldn’t affect production but rather reduce prices to the point that it makes the rational producer have second thoughts about supplying more products. They further argue that hoarded money does not necessarily disappear as consumers will surely have something to spend them on.
Shortcomings of Aggregate Demand
In macroeconomics, aggregate demand measures different transactions of various individuals in millions for several reasons. This poses some difficulties in analyzing variations, regression or efficiently examining casualty as well as collinearity. This is popularly term “aggregation problem” or “ecological inference fallacy” in statistics.
Reference for “Aggregate Demand”
Academics research on “Aggregate Demand”
Credit, money, and aggregate demand, Bernanke, B. S., & Blinder, A. S. (1988). Credit, money, and aggregate demand. Standard models of aggregate demand treat money and credit asymmetrically; money is given a special status, while loans, bonds, and other debt instruments are lumped together in a “bond market” and suppressed by Walras’ Law. This makes bank liabilities central to the monetary transmission mechanism, while giving no role to bank assets. We show how to modify a textbook IS-UI model so as to permit a more balanced treatment. As in Tobin (1969) and Brunner-Meltzer (1972), the key assumption is that loans and bonds are imperfect substitutes. In the modified model, credit supply and demand shocks have independent effects on aggregate demand; the nature of the monetary transmission mechanism is also somewhat different. The main policy implication is that the relative value of money and credit as policy indicators depends on the variances of shocks to money and credit demand. We present some evidence that money-demand shocks have become more important relative to credit-demand shocks during the 1980s.
Aggregate demand management in search equilibrium, Diamond, P. A. (1982). Aggregate demand management in search equilibrium. Journal of political Economy, 90(5), 881-894. Equilibrium is analyzed for a simple barter model with identical risk-neutral agents where trade is coordinated by a stochastic matching process. It is shown that there are multiple steady-state rational expectations equilibria, with all non-corner solution equilibria inefficient. This implies that an economy with this type of trade friction does not have a unique natural rate of unemployment.
Monopolistic competition and the effects of aggregate demand, Blanchard, O. J., & Kiyotaki, N. (1987). Monopolistic competition and the effects of aggregate demand. The American Economic Review, 647-666. How important is monopolistic competition to an understanding of the effects of aggregate demand on output? We ask the question at three levels. Can monopolistic competition, by itself, explain why aggregate demand movements affect output? Can it, together with other imperfections, generate effects of aggregate demand in a way that perfect competition cannot? If so, can it give an accurate account of the response of the economy to aggregate demand movements? The answers are no, yes, and yes.
Fiscal policy and aggregate demand, Aschauer, D. A. (1985). Fiscal policy and aggregate demand. The American Economic Review, 75(1), 117-127.
Government deficits and aggregate demand, Feldstein, M. (1982). Government deficits and aggregate demand. Journal of monetary economics, 9(1), 1-20. The evidence presented in this paper indicates that changes in government spending, transfers and taxes can have substantial effects on aggregate demand. The estimates also indicate that the promise of future social security benefits significantly reduces private saving. Each the basic implications of the so-called ‘Ricardian equivalence theorem’ is contradicted by the data. The results are consistent with the more general view of the effects of fiscal actions and fiscal expectations that is described in the paper.