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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. If you were to represent aggregate demand graphically, the aggregate amount of goods and services demanded is represented on the horizontal X-axis, and the overall price level of the entire basket of goods and services is 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. 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:.
The following are some of the key economic factors that can affect the aggregate demand in an economy. Whether interest rates are rising or falling will affect decisions made by consumers and businesses. Lower interest rates will lower the borrowing costs for big-ticket items such as appliances, vehicles, and homes.
Also, companies will be able to borrow at lower rates, which tends to lead to capital spending increases. Conversely, higher interest rates increase the cost of borrowing for consumers and companies. As a result, spending tends to decline or grow at a slower pace, depending on the extent of the increase in rates. As household wealth increases, aggregate demand usually increases as well.
Conversely, a decline in wealth usually leads to lower aggregate demand. Increases in personal savings will also lead to less demand for goods, which tends to occur during recessions. When consumers are feeling good about the economy, they tend to spend more leading to a decline in savings. Consumers who feel that inflation will increase or prices will rise, tend to make purchases now, which leads to rising aggregate demand.
But if consumers believe prices will fall in the future, aggregate demand tends to fall as well. If the value of the U. Meanwhile, goods manufactured in the U. Aggregate demand will, therefore, increase or decrease. Economic conditions can impact aggregate demand whether those conditions originated domestically or internationally. The mortgage crisis of is a good example of a decline in aggregate demand due to economic conditions.
As a result, banks 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 and 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 and in , which means that the total production in the economy contracted during that period. 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 and the years to follow lead to less aggregate demand by consumers and businesses. As we saw in the economy in and , aggregate demand declined. 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 echoes 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 major debates in economic theory for many years. 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.
Say's law ruled until the s, with the advent of the theories of British economist John Maynard Keynes. Keynes, by arguing that demand drives supply, placed total demand in the driver's seat. Increases and decreases in aggregate demand are shown in Figure 7. Changes in Aggregate Demand. An increase in consumption, investment, government purchases, or net exports shifts the aggregate demand curve AD1 to the right as shown in Panel a.
A reduction in one of the components of aggregate demand shifts the curve to the left, as shown in Panel b. What factors might cause the aggregate demand curve to shift? Each of the components of aggregate demand is a possible aggregate demand shifter. We shall look at some of the events that can trigger changes in the components of aggregate demand and thus shift the aggregate demand curve. Several events could change the quantity of consumption at each price level and thus shift aggregate demand.
One determinant of consumption is consumer confidence. If consumers expect good economic conditions and are optimistic about their economic prospects, they are more likely to buy major items such as cars or furniture. The result would be an increase in the real value of consumption at each price level and an increase in aggregate demand.
In the second half of the s, sustained economic growth and low unemployment fueled high expectations and consumer optimism. Surveys revealed consumer confidence to be very high. That consumer confidence translated into increased consumption and increased aggregate demand. In contrast, a decrease in consumption would accompany diminished consumer expectations and a decrease in consumer confidence, as happened after the stock market crash of The same problem has plagued the economies of most Western nations in as declining consumer confidence has tended to reduce consumption.
A survey by the Conference Board in September of showed that just Similarly pessimistic views prevailed in the previous two months. That contributed to the decline in consumption that occurred in the third quarter of the year. Another factor that can change consumption and shift aggregate demand is tax policy. A cut in personal income taxes leaves people with more after-tax income, which may induce them to increase their consumption.
The federal government in the United States cut taxes in , , , , and ; each of those tax cuts tended to increase consumption and aggregate demand at each price level. In the United States, another government policy aimed at increasing consumption and thus aggregate demand has been the use of rebates in which taxpayers are simply sent checks in hopes that those checks will be used for consumption.
Rebates have been used in , , and In each case the rebate was a one-time payment. Careful studies by economists of the and rebates showed little impact on consumption. Final evidence on the impact of the rebates is not yet in, but early results suggest a similar outcome.
In a subsequent chapter, we will investigate arguments about whether temporary increases in income produced by rebates are likely to have a significant impact on consumption. Transfer payments such as welfare and Social Security also affect the income people have available to spend.
At any given price level, an increase in transfer payments raises consumption and aggregate demand, and a reduction lowers consumption and aggregate demand. Investment is the production of new capital that will be used for future production of goods and services. Firms make investment choices based on what they think they will be producing in the future.
The expectations of firms thus play a critical role in determining investment. If firms expect their sales to go up, they are likely to increase their investment so that they can increase production and meet consumer demand. Such an increase in investment raises the aggregate quantity of goods and services demanded at each price level; it increases aggregate demand.
Changes in interest rates also affect investment and thus affect aggregate demand. We must be careful to distinguish such changes from the interest rate effect, which causes a movement along the aggregate demand curve. A change in interest rates that results from a change in the price level affects investment in a way that is already captured in the downward slope of the aggregate demand curve; it causes a movement along the curve.
A change in interest rates for some other reason shifts the curve. We examine reasons interest rates might change in another chapter. Investment can also be affected by tax policy. One provision of the Job and Growth Tax Relief Reconciliation Act of was a reduction in the tax rate on certain capital gains. Capital gains result when the owner of an asset, such as a house or a factory, sells the asset for more than its purchase price less any depreciation claimed in earlier years.
The lower capital gains tax could stimulate investment, because the owners of such assets know that they will lose less to taxes when they sell those assets, thus making assets subject to the tax more attractive.
Any change in government purchases, all other things unchanged, will affect aggregate demand. An increase in government purchases increases aggregate demand; a decrease in government purchases decreases aggregate demand. Many economists argued that reductions in defense spending in the wake of the collapse of the Soviet Union in tended to reduce aggregate demand.
Similarly, increased defense spending for the wars in Afghanistan and Iraq increased aggregate demand. Dramatic increases in defense spending to fight World War II accounted in large part for the rapid recovery from the Great Depression. A change in the value of net exports at each price level shifts the aggregate demand curve.
For example, several major U. Lower real incomes in those countries reduced U. Exchange rates also influence net exports, all other things unchanged. A rise in the U. That also means that U. Since prices of goods produced in Japan are given in yen and prices of goods produced in the United States are given in dollars, a rise in the U. A higher exchange rate tends to reduce net exports, reducing aggregate demand.
A lower exchange rate tends to increase net exports, increasing aggregate demand. Foreign price levels can affect aggregate demand in the same way as exchange rates. For example, when foreign price levels fall relative to the price level in the United States, U.
Such a reduction in net exports reduces aggregate demand. An increase in foreign prices relative to U. The trade policies of various countries can also affect net exports. A policy by Japan to increase its imports of goods and services from India, for example, would increase net exports in India. A change in any component of aggregate demand shifts the aggregate demand curve. Generally, the aggregate demand curve shifts by more than the amount by which the component initially causing it to shift changes.
Suppose that net exports increase due to an increase in foreign incomes. In either case, incomes will rise, and higher incomes will lead to an increase in consumption. Taking into account these other increases in the components of aggregate demand, the aggregate demand curve will shift by more than the initial shift caused by the initial increase in net exports. In other words, we can use Equation 7. In Panel a of Figure 7. The Multiplier. A change in one component of aggregate demand shifts the aggregate demand curve by more than the initial change.
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