Aggregate demand is a pivotal idea of macroeconomics that simply represents the total demand for all goods and services in an economy. To unpack this concept, we will delve into its definition, dissect the formula that calculates it, and reveal the components that collectively form aggregate demand. Prepare to see economics in action as we explore this cornerstone of macroeconomic theory, which offers a robust framework to understand market dynamics at a national level.
What is the aggregate demand?
Aggregate demand represents the total amount of goods and services that households, businesses, and the government are willing and able to purchase at different price levels. It reflects the overall demand in the economy and influences the level of economic activity. When aggregate demand is high, it stimulates production and economic growth, while a decrease in aggregate demand can lead to a contraction in output and economic slowdown.
Aggregate Demand Definition
Aggregate demand is defined as follows:
Aggregate demand is the total expenditure on goods and services within an economy encompassing consumption by households, investment by businesses, government spending, and net exports (exports minus imports).
Suppose there is an economic downturn, and households become cautious about spending due to concerns about the future. As a result, consumer confidence decreases, leading to a decline in consumer spending on goods and services. Simultaneously, businesses become hesitant to invest in new projects due to the uncertain economic environment. With lower consumer spending and reduced investment, aggregate demand decreases. As a consequence, businesses may experience a decline in sales, leading to reduced production, layoffs, and an overall slowdown in the economy.
What is the aggregate demand formula?
The four main sources of spending in aggregate demand originate from different sectors of the economy. These are households, firms, the government, and exports and imports. We represent these sectors in an equation known as the aggregate demand (AD) equation:
What are the components of aggregate demand?
BasedThe components of aggregate demand are:
- C = Consumption (spending by households).
- I = Investment (spending by firms).
- G = Government spending (spending by the government).
- (X-M) = Exports minus imports (the difference between how much we sell and buy foreign goods and services).
It is very important to understand how components of AD change (increase or decrease) because it is likely to lead to a higher or lower aggregate demand.
Let’s look into the four components of aggregate demand in detail.
Consumption and saving in aggregate demand
Consumption is the total amount of households’ planned spending on goods and services produced in the economy.
Consumer spending is the single largest component of aggregate demand. It made up 60.8% of the nominal GDP (gross domestic product) in June 2021.
The GDP is a quantitative measure that shares the same equation with aggregate demand. You will find more details on this in the Macroeconomic Performance Indicators explanation.
Whenever consumers decide whether or not to spend money on goods and services, they are at the same time deciding whether or not to save. Both consumption and saving are interrelated since a determinant of consumption is also a determinant of household saving.
Saving is the disposable income that is not spent. The process of savings occurs when people decide to postpone their consumption until a future time.
Let’s say Country X has a closed economy. This means they are not exporting nor importing any goods and services. Furthermore, there is no taxation in Country X, meaning that households and firms are not paying taxes to the government. With this in mind, we can assume that households, at any level of income, can either spend it or not. In this scenario, spending their income will result in an increase in consumption, whereas not spending it will result in saving.
Consumption consists of goods with different life spans:
Non-durable goods are consumed in one use or over a short period, e.g. food, petrol, clothes.
Durable goods have a long life span, e.g. automobiles, household appliances, furniture.
There are a variety of determinants that influence consumption and savings:
Interest rates
An interest rate is the reward for saving and the cost of borrowing. It is expressed as a percentage of the money saved or borrowed.
There are various types of interest rates in the economic environment. These include:
Interest rates on savings in the bank and other accounts.
Borrowing interest rates.
Mortgage interest rates (housing loans).
Credit card interest rates and payday loans.
Interest rates on government and corporate bonds.
The interest rate rewards savers for sacrificing their current consumption. The higher the interest rate, the greater the reward will be. Therefore, one could argue that a higher interest rate could lead to lower consumption as households could choose to save to get a higher reward.
Availability of credit
Interest rates are very closely interlinked with the availability of credit. If more credit becomes available and the interest rate is low (meaning that borrowing is cheap), it could encourage households to spend more by supplementing their income with loans from banks. For example, they may choose to get a mortgage, buy a car or go on vacation.
On the flip side, higher interest rates would increase the cost of borrowing, and more households would not be inclined to borrow money from the bank on credit. This could lead to a reduction in overall consumption.
Level of real disposable income
The level of income is perhaps the most important reason for choosing whether to spend or save. Income can be real and disposable. Real income refers to the income adjusted for changes in price levels. Disposable income is the income after all the fixed expenses have been deducted from the paycheck.
If a person earns ‘x’ amount per month, they will need to pay income tax, their national insurance contribution, student loans (if they have them), pension contribution, council tax, rent or mortgage, and so on.
Disposable income is what the person has left when they have paid all those fixed commitments.
Imagine that last year that person could go shopping for groceries and got themselves some new clothes. However, this year the price level increased by 5% and their paycheck remained the same.
That means that the real value of that person’s income has decreased because they are now able to afford less than they were the year before.
British economist John Maynard Keynes proposed a theory of a relationship between income and consumption. He stated that consumption will rise but at a slower rate than the income increase as people will not spend all of the money but also save some.
Furthermore, as people become more affluent, they may become less inclined to spend money on meaningless things, but rather save it to build and maintain their wealth. Keynes argued that such a change in spending mentality was a likely cause of economic crises, particularly, the Great Depression in the 1930s: too much saving, not enough spending.
Referring to the Circular Flow of Income model, there were too many leakages and too few injections into the economy.
Distribution of income and wealth
Distribution of income refers to the wealth balance between the more and less affluent people in the economy, i.e. the so-called rich and poor divide. People with different incomes have different spending habits.
Even though it may seem like it is still spending money, what matters is the purpose. Spending for a new item or spending in order to grow wealth affect different components of aggregate demand.
For example, buying a new car would stimulate C, whilst buying foreign currency would stimulate (X - M).
The government can also regulate the distribution of income by introducing an effective tax system. At the moment, the UK operates a progressive tax system. A progressive system imposes higher rates on higher-income earners as opposed to those on a lower income.
Such a system aims to control how burdensome would the tax be onto the earner and adjust as the income rises or falls. This is done to continue the inflow of money into the government budget, but also to try and equalize the impact on a person’s disposable income by making it proportional to the size of their earnings. The idea is that it is fairer for the bigger earners to carry a heavier tax burden. However, the more tax people need to pay, the less likely they will be to spend money on goods and services, which ultimately affects aggregate demand.
To learn more about different tax rates and allowances in the UK check our explanation on Taxation.
As we already mentioned, the amount of personal wealth a household possesses in addition to their flow of income influences the decisions they make on consumption and savings.
A house is one of the main forms of wealth assets one can own. Rising house prices encourage people to consider becoming homeowners because that could open a door for them to start or continue further building their wealth. Once decided to buy a house, a household may temporarily reduce their consumption to save as much as possible for the deposit on a mortgage. That could impact aggregate demand through a decrease in the C component. However, after the purchase, people may need to buy furniture and do a bit of decorating, which would boost their consumption. They may also see a rise in confidence in their financial future and reduce their saving rate.
For property owners, rising house prices induces a ‘feel-good’ factor as it has the effect of increasing consumer spending sprees. However, as housing prices fall, they have the opposite effect of a ‘feel-bad’ factor as more consumers would take a more precautionary role and start saving more. Such a move would affect the consumer expenditure component in the AD leading to its likely decrease.
Another type of asset that increases wealth is having shares in a firm or in an index. If share prices were to increase, share-owners would be wealthier. They could finance more consumption from the increase in dividends from having shares or from using borrowed funds.
On the flip side, falling stock prices or even a stock market crash would have the opposite effect, as it would reduce the value of the ownership the shareholder has in the company. This could lead to a reduction in overall consumption as the shareholder has recorded a loss in wealth, which could lead to decreases in AD.
Consumer confidence
Consumer confidence is largely dependent on the households’ views on their expected income as well as the changes in their personal wealth. When household optimism rises, the amount of spending on goods and services increases and savings decrease. Conversely, when household optimism decreases, the amount of spending on goods and services will decrease and savings increase.
Just before the first lockdown due to the Covid-19 pandemic was announced people thought they needed a large stock of supplies to survive and started panic buying essential items such as canned food, toilet paper, water, and so on. Such a rapid increase in consumption could have negatively affected the economy if the suppliers were not able to adjust supply in the short run to meet such a demand. In the short run, it could have caused a serious shortage and even a rapid surge in prices.
Personal savings ratio and households savings ratio
The personal savings ratio measures the realised savings of the personal sector as a ratio of the total personal disposable income. This can be realised and shown in a mathematical equation:
The household saving ratio is similar; this particular ratio only measures the household realised saving ratio as a ratio to their disposable income. It is important to realise that the personal sector includes unincorporated businesses such as partnerships or charitable organisations.
This savings ratio is important for economists and economic agents in the government as they wish to understand how much money people are willing and able to save as it could have an effect on the state of the aggregate demand.
Investment in aggregate demand
Investment is spending on capital goods such as factories, plants and machinery, buildings, new technology, and vehicles. Investment is essentially the planned demand for capital goods needed for the production of other goods and services. Firms, for example, can invest in new machinery to produce their goods and services, and governments, for example, can invest in human capital.
Unlike capital, which is characterized as a stock concept, investment is a flow concept. This means, for example, that for capital, we can measure the amount of stock available at a given point in time (it is essentially measuring the total of all capital goods of a nation that are still in production). The flow of investment is usually measured over some time, over one year.
A country usually has two types of investment:
- Replacement investment. In this form of investment, the country chooses to keep the existing amount of capital and replace the capital that is worn out, such as replacing a machine that doesn’t work anymore.
- Net investment. In this form of investment, the country chooses to add to the capital stock, such as investing in new machinery and factories, to increase production potential.
- Both the net investment and the replacement investment make up the country’s gross investment.
Note that investment in the context of understanding aggregate demand should not be confused with the concept of investment in financial markets. In the context of aggregate demand investments solely refer to the planned spendings that firms make on capital goods such as machinery, factories, and other long-term assets. Don’t confuse it with the investments in the stock market.
Factors influencing investment decisions
Investment can be classified into two types of physical capital goods:
- Investments of fixed capital (such as machinery, plants, or factories) and social capital (such as roads and socially owned hospitals).
- Inventory investments in stocks of raw materials such as iron, metal, lithium or other components necessary for production, semi-finished goods such as glass, gold or silver, and finished goods, electronics, food, etc.
Other factors firms need to take into account when making investment decisions are:
- Price of labour.
- Price of capital (the cost of producing the capital as well as the cost of using the capital for the firm).
- Technological development.
- Expected future sales revenue attributed to the new machinery.
- Expected costs of production from the machinery and interest payments made from the borrowing to fund the machinery in the first place.
- Maintenance costs of the machinery.
- Expected future profit to be yielded from the machinery.
Government spending in aggregate demand
Government spending is a key component of aggregate demand. The decisions of a government on where to spend the money can have a big regional impact to promote economic activity. It is also important that the government spends more money on the public to provide merit as well as public goods.
Government spending is the spending of the public sector of the economy on goods and services.
There are three forms of government spending:
Welfare spending. Otherwise known as transfer payments. As an example, we can look at the welfare offered by the UK: social welfare services such as job seeker allowances, universal credit welfare rates, etc.
Recurring spending. Otherwise known as public services such as police, fire brigade, state education, national health services, local authority services.
State investments. Otherwise known as capital investments, this is spending on capital goods needed to provide public services such as infrastructure, public buildings, etc.
Other main examples of government spending include the field of education where the state invests in building schools or public infrastructures such as roads, health care (hospitals), and defence (military).
Net exports in aggregate demand
Before looking at the concept of net exports let’s quickly revisit the definition of exports and imports.
Exporting is the act of selling goods and services to another country, whereas importing is the act of receiving goods and services from another country.
The net exports of a country, otherwise known as net trade balance, is the difference between the value of exports minus imports (X - M). If the value of the exports of a country is greater than the value of imports, the trade balance is in surplus. When the value of the imports of a country is greater than the value of exports, the trade balance of that country is in deficit.
The income generated from these exports from the perspective of the exporting country is seen as an injection into the circular flow of income and adds to the aggregate demand (AD).
Factors influencing the trade balance
Relative prices of goods and services in the world markets. For example, the prices of certain goods and services may vary between the UK and Germany or between the UK and China. Chinese goods and services will be cheaper, for example, due to the fact that the cost of production of these goods and services is vastly cheaper. Their quality is also lower than that of goods produced in Germany.
The exchange rate. Usually, a stronger currency makes exports more expensive as to buy the goods and services, a nation first has to acquire the necessary currency whose price is costlier in relation to the nation’s own currency. For example, if the Sterling pound were to appreciate and increase in value against the Euro, it would mean that European countries would have to first buy the costlier British pounds to import goods and services from the UK. In addition, from the UK’s point of view, imports from the European Union would become cheaper as the value of the British pound would have appreciated in comparison to the Euro.
Strength of aggregate demand in key export markets. If the UK exports 10% of its goods and services to the US due to strong trade ties, and the US, for example, enters a recession due to lower AD, it would be difficult for the UK to find new key export markets as aggregate demand for UK goods and services in the US would be low and UK exports towards the US would decrease.
Non-price demand factors, for example how effective and good are the designs, innovations, branding and performance of the goods and services that are being exported.
Aggregate demand and the level of economic activity
Economic activity is the process of production and consumption of goods and services in an economy at a particular time. It takes into account the employment of labour, capital, and other inputs that produce output.
In this context, economic activity will also hold a relation to the employment levels in an economy as we are trying to realise the relationship between the aggregate demand and real output. When the real output increases, businesses have to hire more labour/workers in order to produce more goods and services, and that process alone involves a large labour supply. Conversely, when real output decreases, firms tend to demand less labour as there is little demand to produce these goods and services
Aggregate Demand - Key takeaways
- Aggregate demand is a measure of total expenditure on a country’s goods and services. It measures the total amount of spending in an economy.
- The four components of aggregate demand are consumption, investments, government spending, and net exports.
- Consumption refers to the total amount of planned spending by households on goods and services that are produced in the economy.
- Investment can be referred to as spending on capital goods such as factories, plants and machinery, buildings, new technology, and vehicles.
- Government spending is spending by the public sector of the economy on goods and services such as education, public infrastructure, health care, and defence.
- The net exports of a country, otherwise known as net trade balance, is the difference between the value of exports and imports.
- Economic activity is the process of production and consumption of goods and services in an economy at a particular time. It takes into account the employment of labour, capital, and other inputs that produce output.
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