Aggregate Demand , Calculation, & Examples

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.

Understanding Aggregate Demand

A macroeconomic term, aggregate demand 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.

Drawbacks of Aggregate Demand

While aggregate demand is helpful in determining 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.

Also, aggregate demand measures many different economic transactions between millions of individuals and for different purposes. As a result, it can become difficult to determine the causality of demand and run a regression analysis, which is used to determine how many variables or factors influence demand and to what extent.

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:

Aggregate Demand = C + I + G + Nx where: C = Consumer spending on goods and services I = Private investment and corporate spending on non-final capital goods (factories, equipment, etc.) G = Government spending on public goods and social services (infrastructure, Medicare, etc.) Nx = Net exports (exports minus imports) \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 spending onnon-final capital goods (factories, equipment, etc.)G=Government 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.

Factors That Influence Aggregate Demand

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

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.

The crises had a severe impact on banks and financial institutions. As a result, they reported widespread financial losses leading to a contraction in lending, as shown in the graph on the left below. With less lending in the economy, business spending and investment declined. From the graph on the right, we can see a significant drop in spending on physical structures such as factories as well as equipment and software throughout 2008 and 2009. (Data is based on the Federal Reserve Monetary Policy Report to Congress of 2011.)

Bank Loans and Business Investment 2008.  Investopedia

With businesses suffering from less access to capital and fewer sales, they began to layoff workers. The graph on the left shows the spike in unemployment that occurred during the recession. Simultaneously, GDP growth also contracted in 2008 and in 2009, which means that the total production in the economy contracted during that period.

Unemployment and GDP 2008.  Investopedia

The result of a poor performing economy and rising unemployment was a decline in personal consumption or consumer spending — highlighted in the graph on the left. Personal savings also surged as consumers held onto cash due to an uncertain future and instability in the banking system. We can see that the economic conditions that played out in 2008 and the years to follow lead to less aggregate demand by consumers and businesses.

Consumption and Savings 2008.  Investopedia

Aggregate Demand Controversy

Aggregate demand definitely declined in 2008 and 2009. However, there is much debate among economists as to whether aggregate demand slowed, leading to lower growth or GDP contracted, leading to less aggregate demand. Whether demand leads 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.

The relationship between growth and aggregate demand has been the subject of major debates in economic theory for many years.

Historical Debate

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.

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. According to their demand-side theory, 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. In other words, producers look to rising levels of spending as an indication to increase production.

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, hearken back to Say. They 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 maldistributions 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 on 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 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.

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.