Aggregate Demand

What Is Aggregate Demand?

Aggregate demand is a term used in macroeconomics to describe the total demand for goods produced domestically, including consumer goods, services, and capital goods. It adds up everything purchased by households, firms, government and foreign buyers (via exports), minus that part of demand that is satisfied by foreign producers through imports. This is often written as C + I + G + (X-M), where C is personal consumption expenditures, I is investment, G is government purchases of goods and services, X is exports, and M is imports. Together, this is all of Gross Domestic Product, or GDP.

What determines the level of aggregate demand? Keynesians have one view. Monetarists have a different view. And there is a synthesis of the two views known as IS-LM.

Keynesians focus on the ability of investment to absorb desire saving. If firms desire high levels of investment and/or consumers are eager to spend rather than save, then aggregate demand will be high. But if consumers are anxious to save while firms are reluctant to investment, then aggregate demand will be low.

More generally, Keynesians see the flow of spending in terms of injections and leakages. Investment, government spending, and exports all inject demand into the economy. Saving, taxes, and imports all leak demand out out of the economy. When demand is weak, the government can remedy this by injecting more of its own spending or by reducing leakage by cutting taxes. In either case, its own budget moves in the direction of deficit.

Monetarists see aggregate demand as determined by what is called the amount of money in circulation. American monetarists write MV = PY, where M is the quantity of money, V is the velocity of money, P is the aggregate price of output, and Y is aggregate output, or real GDP.

The idea is that households and businesses use money to facilitate purchases of goods and services. The total value of goods and services purchased is nominal GDP, which by definition is PY. At any one point in time, households and firms are holding some cash on hand. The velocity of money measures how quickly they turn over their cash to buy more goods and services. Velocity depends technology, habits, and what we consider to be the definition of “money.”

One advantage of the monetarist approach is that it introduces the price level into aggregate demand. Taking the supply of money and the velocity of money as given, the demand for real output will be higher if the price level is lower. This means that we can draw a downward-sloping aggregate demand curve, just like the demand curve in microeconomics.

A synthesis that was developed in 1937 by John Hicks, called IS-LM, was popular for several decades. In the IS-LM formulation, both the money supply and the saving-investment balance affect aggregate demand.

We can think of IS-LM as introducing the interest rate as a determinant of the velocity of money. Suppose that the government increases spending, which is an injection. This will raise the interest rate and increase the velocity of money, so that nominal GDP will increase.

Although macroeconomists are comfortable with the concept of aggregate demand, it is inconsistent with classical economics. In classical economics, one does not speak of total demand, as if the economy were one giant firm. Demand does not fall for the economy as a whole. Instead, when demand falls for one good, it goes up for some other good.

Related Topics

Phillips Curve. Concise Encyclopedia of Economics.

Aggregate Supply. Economics Topics Detail.