Aggregate Demand definition
Aggregate demand is a macroeconomic variable that measures the total demand of all finished goods and services produced within an economy. It is expressed in monetary terms, at a specified price level, at a point in time. Aggregate demand refers to the total amount in USD, GBP, JPY, ZAR, or any other currency that is spent on goods and services, including capital goods, consumer goods, imports, exports, as well as government expenditure. The aggregate demand figure represents the total amount of money exchanged for all goods and services. It is effectively the total demand for the gross domestic product (GDP) of a country.
The formula for calculating AD (Aggregate Demand) = C (Consumer Expenditure) + I (Investment on Computers, Factories, Equipment, et al) + G (Government Expenditure on Roads Railways, Bridges, Hospitals, Healthcare et al) + (X (Exports) – M (Imports)). AD can be represented graphically by plotting the Aggregate Demand for Goods & Services on the horizontal X-axis, and the prevailing Price Level of all goods and services is represented on the vertical Y-axis. As is standard with AD curves, this downward-sloping curve reflects a decrease in demand for goods and services as price increases, and an increase in demand for goods and services as price decreases.
AD and GDP
Aggregate Demand (AD) is a measure of the total value of money exchanged for all finished goods and services produced within a country during a specified period. Gross Domestic Product (GDP) is the metric used to determine the monetary value of all finished goods and services produced within a country during a specified period of time. These are both macroeconomic variables. GDP is calculated in 3 ways, notably:
- Total value of Goods & Services sold
- Income Payments + Production Costs
- All Value Added during each stage of production
AD is technically considered ‘total planned expenditure’ and it is comprised of C+I+G+[X-M]. AD is largely determined by several factors, notably price. As is standard with demand curves, a decrease in price is associated with an increase in demand. The reasons for this include the ‘Wealth Effect’. Since rising prices tend to eat into the buying power of savings, it naturally follows that inflationary pressures reduce expenditure in the economy. Foreign price levels can affect AD too. If prices rise in one country relative to another, then it stands to reason that exports from the more expensive country will fall and imports will rise. This leads to higher domestic prices, and lower AD.
Another factor influencing AD is interest rates. As the interest rate rises, the cost of borrowed capital increases. This means that it becomes more expensive for companies to borrow money, which then curbs borrowing and investment in the economy. This filters all the way down from businesses to households. AD therefore decreases when the costs of borrowing money increases. Inflation, foreign prices, and interest rates can affect AD, but it is largely a function of price. The lower the prices, the greater the AD. The higher the prices, the lower the AD.
Limitations of Aggregate Demand
AD represents aggregate demand/aggregate production at specified price levels. It does not indicate anything pertaining to the standard of living, or the quality of life in the country. AD measures many different economic transactions, for all individuals in a specified country. Given its broad-spectrum nature, it is difficult to ascertain what causes the demand and assess how different factors influence overall demand. Eventually, AD equals GDP, since the two metrics are determined in the same way. Consequently, both of these metrics will rise or fall in unison.