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Aggregate demand

In macroeconomics, aggregate demand is the total demand for final goods and
services in the economy (Y) at a given time and price level[1]. It is the amount of
goods and services in the economy that will be purchased at all possible price levels.
[2]
This is the demand for the gross domestic product of a country when inventory
levels are static. It is often called effective demand or abbreviated as 'AD'. 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,
the Keynes' interest rate effect 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.[3]

where

• is consumption = ac + bc(Y − T),


• is Investment,
• is Government spending,
• is Net export,
o is total exports, and
o is total imports = am + bm(Y − T).
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. The consumption function is C= a + (mpc)(Y-T)
o a is autonomous consumption, mpc is the marginal propensity to
consume, (Y-T) is the disposable income.

• gross private domestic investment (I), such as spending by business firms on


factory construction. This includes all private sector spending aimed as the
production of some future consumable.
o 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 (Ip) is counted as part
of aggregate demand. (So, I does not include the 'investment' in
running up or depleting inventory levels.)
o Investment is affected by the output and the interest rate (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, when Y goes up, the investment will increase.

• gross government investment and consumption expenditures (G).


• net 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 terms.

Two Concepts of the "Aggregate Demand Curve"


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

Main article: Keynesian cross

Keynesian cross diagram

In the "Keynesian cross diagram," a desired total spending (or aggregate expenditure,
or "aggregate demand") curve (shown in blue) is drawn as a rising line since
consumers will have a larger demand with a rise in disposable income, which
increases with total national output. This increase is due to the positive relationship
between consumption and consumers' disposable income in the consumption function.
Aggregate demand may also rise due to increases in investment (due to the accelerator
effect), while this rise is reduced if imports and tax revenues rise with income.
Equilibrium in this diagram occurs where total demand, AD, equals the total amount
of national output, Y, (which corresponds to total national income or production).
Here, total demand equals total supply.

In the diagram, the equilibrium level of output and demand is determined where this
desired spending curve intersects a line that represents the equality of total income
and output (AD=Y). The intersection gives the equilibrium output, Y'.

The movement toward equilibrium is mostly via changes in inventories which induce
changes in production and income. If current output exceeds the equilibrium,
inventories accumulate, encouraging businesses to cut back on production, moving
the economy toward equilibrium. Similarly, if the level of production is below the
equilibrium, then inventories run down, encouraging an increase in production and
thus a move toward equilibrium. This equilibration process occurs when the
equilibrium is stable, i.e., when the AD line is less steep than the AD=Y line.

The equilibrium level of output determines the equilibrium level of employment in the
model. (In a dynamic view, these are connected by Okun's Law.) There is no reason
within the model why the equilibrium level of employment should correspond to full
employment. Bringing in other considerations may imply this correspondence,
though.

If any of the components of aggregate demand (C + Ip + G + NX) rises at each level


of income, for example because business becomes more optimistic about future
profitability, that shifts the entire AD line upward. This raises equilibrium income and
output. Similarly, if the elements of AD fall, that shifts the line downward and lowers
equilibrium output. (The AD=Y line does not shift under the definition used here).

Aggregate Demand-Aggregate Supply model

Main article: AD-AS 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.

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), 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 supply (Ms) is constant, a falling P implies that the real money supply
(Ms/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 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 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 (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.

[edit] Marxian critique

In Marxian economics, the equation of aggregate demand with expenditure on GDP


or GNP is rejected as false, on conceptual and statistical grounds.

Firstly, GDP as a measure of value added excludes purchases of all intermediate


goods and services 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.

Secondly, Gross Output 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.

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

Fourthly, 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.