Aggregate demand

What is Aggregate Demand?

Aggregate demand is the total amount of goods and services demanded by a country, at a given price level, over a given period of time.

Aggregate demand, which can be measured, captures exactly the same idea as GDP. That’s why economists often use both terms as synonyms.

Aggregate Demand: A Simple Explanation

Aggregate demand adds up everything that households, businesses, the government and foreign buyers are willing to purchase in a country at a certain price level. It works like a normal demand curve from microeconomics, but scaled up to an entire economy.

When prices rise, aggregate demand tends to fall, since money buys less and people and companies cut back on spending. When prices fall, the opposite happens: households and businesses can afford to buy more, so aggregate demand goes up.

This concept matters because, together with aggregate supply, it is one of the two pillars economists use to explain how prices and output are determined in an economy. It also explains why aggregate demand and GDP are treated as equivalent: both add up the value of everything produced and spent during the same period.

How to calculate

Aggregate demand can be calculated with the same methods used for GDP. However, it is associated with expenditure, so it is worked out from the spending side, that is, from what society as a whole has spent.

This calculation takes into account household expenditure, investment spending, government expenditure and, finally, net exports, which is the difference between exports and imports. The formula for aggregate demand looks like this:

DA = C + I + G + (X-M)

On the other hand, domestic demand is the expenditure on goods and services (public (G) and private (C)) and investment (I) made by the residents of a country during a given period of time. Aggregate demand can therefore also be expressed as:

DA = Domestic demand + net exports

This is what each component means:

• Consumption (C): household expenditure on goods and services, including those produced abroad.
• Investment (I): all the investments made by companies, such as machinery, capital goods or housing.
• Public expenditure (G): purchases made by any public administration in exchange for goods and services. This does not include spending on unemployment benefits, pensions, etc., since these are transfers, not payments for goods or services.
• Net exports: exports minus imports.
  • Exports (X): products made in one country and purchased by residents of other countries.
  • Imports (M): goods and services produced abroad and purchased by the country’s residents. Subtracting them leaves only the spending that stays within the country.

All sectors where expenditure may have occurred are taken into account, but it also matters where the goods were produced, which is why exports and imports are included. If exports are higher than imports, it means the country has sold more than it has bought, a positive difference that adds to the rest of the spending, and vice versa.

The aggregate demand curve

The aggregate demand curve graphically represents all combinations of the price level and national output, drawing on both the money market and the goods market. The higher the prices, the lower the aggregate demand. The IS-LM model is the tool used to build this curve.