Aggregate Demand

A College Economics Guide

Supplementary resources for college students

Introduction

Aggregate demand is the total amount of goods (including services) demanded by businesses within a country at a given price level.

Although the word “aggregate” makes it sound as if something economists call “aggregate demand” should be the sum of all of a country’s demand curves, it is not exactly that.

For an individual good–such as toothpaste or barber services–the higher the price, the less of that good people demand. However, if you buy less toothpaste, you have a bit more money left to buy something else. Most consumer goods and services have substitutes. So, buying less toothpaste means consumers might buy more mouthwash, more dental services, or more baking soda, which can be used to make homemade toothpaste. In aggregate, the total quantity of goods demanded may fall very little, if at all, when the price of a good rises.

Instead, economists classify an economy’s demand into four components: consumption goods (such as cell phones, toothpaste, barber services), investment goods (such as machinery or research), government goods (such as roads or military services), and international goods (exports–which are goods produced in the economy that are bought by foreigners–versus imports–foreign goods demanded by the economy’s own citizens).

When considering consumption goods, economists have proposed that in aggregate, the proportion of consumption goods demanded depends on how people’s current income compares to their expectation of future income. In a good year or when people are young, people may earn more money than they expect to earn in the future; so, they might save a higher proportion of their earnings for the future. Aggregate demand for consumption goods, at least as a proportion of income, may fall because of these temporary windfalls during good times or because of the natural cycle of life.

Interest rates and inflation also influence the quantity of consumption goods demanded.

Definitions and Basics

Aggregate Demand. An Economics Topics Detail.

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.

Keynesian Economics, from the Concise Encyclopedia of Economics

Keynesian economics is a theory of total spending in the economy (called aggregate demand) and of its effects on output and inflation….

New Classical Macroeconomics, from the Concise Encyclopedia of Economics

According to Keynes, the classics saw the price system in a free economy as efficiently guiding the mutual adjustment of supply and demand in all markets, including the labor market. Unemployment could arise only because of a market imperfection–the intervention of the government or the action of labor unions–and could be eliminated through removing the imperfection. In contrast, Keynes shifted the focus of his analysis away from individual markets to the whole economy. He argued that even without market imperfections, aggregate demand (equal, in a closed economy, to consumption plus investment plus government expenditure) might fall short of the aggregate productive capacity…

National Income Accounts, from the Concise Encyclopedia of Economics

The broadest and most widely used measure of national income is gross domestic product (GDP), the value of expenditures on final goods and services at market prices produced by domestic factors of production (labor, capital, materials) during the year. It is also the market value of these domestic-based factors (adjusted for indirect business taxes and subsidies) entering into production of final goods and services. “Gross” implies that no deduction for the reduction in the stock of plant and equipment due to wear and tear has been applied to the measurements and survey-based estimates. “Domestic” means that the GDP includes only production by factors located in the country—whether home or foreign owned…..

In the News and Examples

Ricardo Reis on Keynes, Macroeconomics, and Monetary Policy. Podcast episode on EconTalk, April 27, 2009.

Ricardo Reis of Columbia University talks with EconTalk host Russ Roberts about Keynesian economics in the classroom and in research. Reis argues that Keynesian models are a useful framework for helping undergraduates understand macroeconomic ideas of general equilibrium. More generally, Reis argues, Keynesian ideas remain influential in macroeconomic research, particularly among Neo-Keynesians. Reis discusses the lessons the economics profession and the world have learned from the Great Depression and suggests that those lessons have helped us manage the current crisis. The conversation closes with a discussion of whether economics is a science.

Fiscal Policy, from the Concise Encyclopedia of Economics

This ability of fiscal policy to affect output by affecting aggregate demand makes it a potential tool for economic stabilization. In a recession, the government can run an expansionary fiscal policy, thus helping to restore output to its normal level and to put unemployed workers back to work. During a boom, when inflation is perceived to be a greater problem than unemployment, the government can run a budget surplus, helping to slow down the economy. Such a countercyclical policy would lead to a budget that was balanced on average….

Effects of trying to boost the economy via aggregate demand during business cycles: Gross Domestic Product, from the Concise Encyclopedia of Economics

In the short run, in business cycles the Keynesian emphasis on demand is relevant and alluring. But heavy-handed reliance on “demand management” policies can distort market prices, generate major inefficiencies, and destroy production incentives. India since its independence and Peru in the eighties are classic examples of the destruction that demand management can cause. Other less developed countries like South Korea, Mexico, and Argentina have shifted from an emphasis on government spending and demand management to freeing up markets, privatizing assets, and generally enhancing incentives to work and invest. Rapid growth of GDP has resulted….

Reducing Real Output by Increasing Federal Spending, by Dwight R. Lee.

The belief that by spending more, the federal government can revive the economy by increasing aggregate demand is an example of the triumph of hope over experience. Many people excuse the recent failures of such stimulus spending with the claim that the spending simply wasn’t large enough. This demand-side view is oblivious to the supply-side reality that demanding more does no good unless more has been, or will be, produced. The logic of this reality explains why trying to increase aggregate demand through increased federal spending is not the key to stimulating the economy. The problem is not that aggregate demand is unimportant–it is very important. The problem is that increased realaggregate demand is the result, not the cause, of an increasingly productive and prosperous economy….

A Little History: Primary Sources and References

John Maynard Keynes, biography from the Concise Encyclopedia of Economics

Keynes’s General Theory revolutionized the way economists think about economics. It was pathbreaking in several ways, in particular because it introduced the notion of aggregate demand as the sum of consumption, investment, and government spending; and because it showed (or purported to show) that full employment could be maintained only with the help of government spending. Economists still argue about what Keynes thought caused high unemployment….

John R. Hicks, biography from the Concise Encyclopedia of Economics

His second major contribution is his invention of what is called the IS-LM model, a graphical depiction of the argument John Maynard Keynes gave in his General Theory of Employment, Interest and Money (1936) about how an economy could be in equilibrium with less than full employment. Hicks published it in a journal article the year after Keynes’s book was published. It seems safe to say that most economists became familiar with Keynes’s argument by seeing Hicks’s graph….

Advanced Resources

Steve Fazzari on Keynesian Economics, podcast on EconTalk. Jan. 12, 2009.

Steve Fazzari, of Washington University in St. Louis, talks with EconTalk host Russ Roberts about Keynesian economics. Fazzari talks about the paradox of thrift, makes the case for a government stimulus plan, and weighs the empirical evidence for a Keynesian worldview….