Aggregate Demand

Aggregate Demand

Aggregate demand is the total spending of all the units that make up the large economy or macroeconomy. The economy comprises smaller units or agents such as households, firms, government and the trade sector.  The household is made up of individual consumers; firms convert inputs into finished products while the government regulates the economy and provides a conducive environment for economic activities to thrive. The trade sector comprises exports and imports. The aggregate demand is made of consumption, investment, government spending and net exports. And a change in any of them will lead to a change in the aggregate demand.

Image showing formula of AD

C = Consumption
I = Investment
G = Government spending
X = Export
M = Import
X-M = Net exports

Consumption is the spending by households on final products. The factors that can influence consumption and, by extension, aggregate demand include a change in disposable income, wealth, interest rate, availability of credit products and consumer confidence. These factors are capable of increasing aggregate demand if they increase consumption or contracting aggregate demand if they decrease consumption. Disposable income is the income available for spending after the deduction of taxes. A rise in disposable incomes, for example, due to lower income taxes will increase the expenditure of consumers on both durable and non-durable goods produced in the country. Besides, an increase in the stock of assets (wealth) possessed by individuals will increase their purchasing power and hence their consumption as wealth produces incomes that can be spent. If it is cheaper for people to borrow because the central bank has lowered the interest rate, more people will obtain loans to increase their expenditures on goods and services. Consumption will also increase if there is the availability of many credit products such as hire purchases, overdrafts, mortgage, personal loans, car loans and instalmental payments. Consumer confidence or optimism of consumers about economic prospects and their own future financial circumstances can determine how much of their present income they will spend or save.

Expenditure on capital goods is known as investment. Capital goods are goods that help to produce other goods, e.g. machinery, equipment, tools, etc.
A key influence on investment spending by firms is the rate of interest. A higher interest rate discourages investment because the cost of borrowing is high while a lower interest rate encourages investment. Besides, firms will be reluctant to invest if the expected return (profit on investment) is low, especially when compared to the cost of borrowing money for investment. Expected sales can be deduced from the Gross Domestic Product (GDP); a falling GDP in a country, for example, during a recession, is an indication that incomes and sales will be low and firms will not undertake new investments. More investments will be undertaken now if businesses are confident or positive about sales or production in the near future. Positive business confidence could suggest that economic activities will rise in the immediate future.

Government spending
The government spends money on roads, railways, ports, defence, agriculture, electricity, etc. The amount expended by the government is determined by the state of the economy and political considerations. For instance, an economy going through recession would require more spending to boost aggregate demand and create jobs. On the other hand, the government may have to reduce its spending in order to curb inflation, thereby reducing aggregate demand.

The government may have to spend on certain projects based on political considerations, e.g. in order to have the support of the populace. Sometimes, it may embark on projects in certain areas with a high voter population when elections are close with the intention of persuading them to vote in its favour.

Furthermore, the budget lays out what government intends to spend on based on its priorities such as food security, economic prosperity, equitable distribution of income, living standards improvement, environmental protection, etc. 

Net exports
Net exports refer to the difference between exports and imports. A fall in exchange rate of, say, the USA will make its exports cheaper and imports more expensive. Consequently, exports increase while imports decrease, leading to a rise in net exports and aggregate demand of the USA.  A rise in the domestic inflation rate will make domestic products less competitive in the international markets thereby reducing exports of a country and aggregate demand. In addition, a global recession will lead to fall in incomes in different countries which will reduce demand for  a country’s exports. Conversely, a rise in incomes of citizens of a trading partner will, invariably, result in a rise in demand for a country’s products abroad.

Aggregate demand curve

It is a downward-sloping curve that shows the inverse relationship between the price level and the real GDP.
When the price level is increasing, it means that on the average prices of an economy’s products are rising, i.e. prices of most goods and services are going up. That is to say, rising price level indicates there is inflation im the economy. 

As the price level rises, the real GDP or total expenditure in the economy decreases and vice versa. It means that  when the price level goes up, aggregate demand expands and versa. This is because the formula for GDP by the expenditure method is the sames as the one for aggregate demand, i.e. C+I+G+(X-M).

Why is there an inverse relationship between price level and aggregate demand?

A rising price level indicates that there is inflation. Therefore, domestic goods become unattractive to foreigners while foreign- made goods are relatively cheaper for the country’s citizens.  Exports will reduce while and imports will increase. A fall in exports and a growth in imports result in a decline in net exports and aggregate demand (international effect). Remember that net exports is a component of aggregate demand.

Consumption, another component of aggregate demand, will fall as price level is rising. This is because people’s purchasing power is reduced and they become poorer. The value of  their wealth also declines. Therefore, consumption falls and aggregate demand shrinks when the price level rises (wealth  or real balance effect). 

A rise in inflation rate or price level will make people demand for more money to meet up with their purchases. Rising demand for money pushes interest rate up, thereby reducing borrowing and consumption. People will rather save to get higher interest and consume less. Less borrowing and more savings will reduce consumption and aggregate demand (interest rate effect).


Movement along the aggregate demand curve and shift in the aggregate demand curve
A movement along the agregate demand curve is caused by a change in the price level. If the price level increases from PL1 to PL2 as in Figure 1 below, there will be an upward movement along the curve signalling that the amount of aggregate demand has decreased from Y1 to Y2 (contraction of aggregate demand). The amount of aggregate demand will rise from Y1 to Y2 when there is a decrease in the price level from PL1 to PL2 (Figure 2 below) and the movement will be downward the curve (extension of aggregate demand).

Figure 1: Contraction of aggregate demand

Diagram showing the contraction of aggregate demand

Figure 2: Extension of aggregate demand

A diagram showing the extension of aggregate demand

A shift in the aggregate demand curve could be rightward or leftward. A rightward shift means that aggregate demand has increased (Figure 3 below) while a leftward shift shows that aggregate demand has decreased (Figure 4 below).  A shift results in drawing another aggregate demand curve and is caused by a change in any of the components of aggregate demand, e.g. a fall in investment. 

Figure 3: An increase in aggregate demand

A diagram showing increase in aggregate demand


Figure 4: A decrease in aggregate demand

A diagram showing  decrease in aggregate demand