Aggregate demand

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Jump to: navigation, search In economics, aggregate demand is the total demand for goods and services in the economy (Y) during a specific time period. Moreover, the aggregate demand is kno n as the amount of stuff people ant to !uy. "he aggregate demand function is represented as : #d$ %&I&'&(). "his function sho s that the aggregate demand e*ual to the sum of consumption (%), Investment (I), 'overnment spending (') and the (et e+port (()). In fact, many people ould ask a!out the relationship !et een output and the price level. ,oes changing in the prices effect the output-. "he ans er is yes, !ut many economics !ooks assume that the price level is constant .ust to make the relationships among the economic factors very simple. It is often called effective demand. /ut another ay, it is the demand for the gross domestic product of a country hen, and only hen, it is in e*uili!rium (the total ne production sold through the market). "his demand consists of four ma.or parts, hich can !e stated in either nominal or 0real0 terms:

personal consumption e+penditures (C) or 0consumption,0 demand !y households and unattached individuals1 its determination is descri!ed !y the consumption function. "he consumption function is %$ a & (mpc)(#2")

a is autonomous consumption, mpc is the marginal propensity to consume, (#2") is the disposa!le income.

gross private domestic investment (I), demand !y !usiness firms and some individuals, for ne factories, machinery, computer soft are, housing, other structures, and inventories. In addition, Investment is effected !y the output and the interest rate (i). %onse*uently, e can rite it as I(#,i). Investment has positive relationship ith the output and negative relationship ith the interest rate. For e+ample, hen # goes up, the investment ill increase. gross government investment and consumption e+penditures (G). net e+ports (NX and sometimes (X-M)), i.e., net demand !y the rest of the orld for the country3s output.

In 4eynesian economics, not all of gross private domestic investment counts as part of aggregate demand. Much or most of the investment in inventories can !e due to a short2 fall in demand (unplanned inventory accumulation or 0general over2production0). (Inventory accumulation ould correspond to an e+cess supply of products1 in the (ational Income and /roduct 5ccounts, it is treated as a purchase !y its producer.) "hus, only the planned or intended or desired part of investment (Ip) is counted as part of aggregate demand.

In sum, for a single country at a given time, aggregate demand (D or AD) $ C & Ip & G & (X-M). 6trictly speaking, it is *uestiona!le hether this aggregation is possi!le, as it is impossi!le to form such macrovaria!les from some microvaria!les: ho do you add up litres of gasoline and tooth!rushes- In the sense of nominal monetary values (prices) this is possi!le1 !ut in the sense of real goods it is not. "herefore it might !e argued that an 0aggregate demand curve0 does not even e+ist in an (income,spending)2space.

Contents
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9 " o %oncepts of the 05ggregate ,emand %urve0 o 9.9 4eynesian %ross o 9.: Marshallian %ross o 9.; Mar+ian criti*ue : 6ee also ; <+ternal links

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Two Concepts of the "Aggregate Demand Cur e"

5 person3s understanding of the aggregate demand curve depends on hether he or she e+amines changes in demand as income changes or as price change. 7edit8

!e"nes#an Cross

In the 04eynesian cross diagram,0 a desired total spending (or aggregate expenditure, or 0aggregate demand0) curve is often dra n as a rising level of D as total national output and income rise. "his increase is due to the positive relationship !et een C and consumers3 disposa!le income in the consumption function. It may also rise due to increases in investment (due to the accelerator effect), hile this rise is reduced if imports and ta+ revenues rise ith income. <*uili!rium in this diagram occurs here total spending (D) e*uals the total amount of national income ( hich corresponds to total national output or production). =ere, total demand e*uals total supply. In the diagram, the e*uili!rium level of output, income, and demand is determined here this desired spending curve intersects the 0$ curve,0 a line that represents the e*uality of total income and output. "his is at point %, determining the e*uili!rium levels of output and income on the hori>ontal a+is ( here the arro points). "he movement to ard e*uili!rium is mostly via changes in inventories inducing changes in production and income. If current output e+ceeds the e*uili!rium, inventories accumulate, encouraging !usinesses to cut !ack on production, moving the economy to ard e*uili!rium. 6imilarly, if the level of production is !elo the e*uili!rium, then inventories run do n, encouraging an increase in production and thus a move to ard e*uili!rium. "his e*uili!ration process occurs hen the e*uili!rium is sta!le, i.e., hen the D line is steeper than the $ line. "he e*uili!rium level of output determines the e*uili!rium level of employment in the model. (In a dynamic vie , these are connected !y ?kun3s @a .) "here is no reason ithin the model hy the e*uili!rium level of employment should correspond to full employment. Aringing in other considerations may imply this correspondence, though. If any of the components of aggregate demand (C & Ip & G & NX) rises at each level of income, for e+ample !ecause !usiness !ecomes more optimistic a!out future profita!ility, that shifts the entire D line upward. "his raises e*uili!rium income and output. 6imilarly, if the elements of D fall, that shifts the line do n ard and lo ers e*uili!rium output. ("he $ line does not shift under the definition used here.) 7edit8

Marsha&&#an Cross
6ometimes, especially in te+t!ooks, 0aggregate demand0 refers to an entire demand curve that looks like that in a typical Marshallian supply and demand diagram.

"hus, that e could refer to an 0aggregate *uantity demanded0 (Yd $ C & Ip & G & NX in real or inflation2corrected terms) at any given aggregate average price level (such as the ',/ deflator), '. In these diagrams, typically the Yd rises as the average price level (') falls, as ith the AD line in the diagram. "he main theoretical reason for this is that if the nominal money supply (Ms) is constant, a falling ' implies that the real money supply (MsB')rises, encouraging lo er interest rates and higher spending. "his is often called the 04eynes effect.0 %arefully using ideas from the theory of supply and demand, aggregate supply can help determine the e+tent to hich increases in aggregate demand lead to increases in real output or instead to increases in prices (inflation). In the diagram, an increase in any of the components of AD (at any given ') shifts the AD curve to the right. "his increases !oth the level of real production (Y) and the average price level ('). Aut different levels of economic activity imply different mi+tures of output and price increases. 5s sho n, ith very lo levels of real gross domestic product and thus large amounts of unemployed resources, most economists of the 4eynesian school suggest that most of the change ould !e in the form of output and employment increases. 5s the economy gets close to potential output (Y(), e ould see more and more price increases rather than output increases as AD increases. Aeyond Y(, this gets more intense, so that price increases dominate. Worse, output levels greater than Y( cannot !e sustained for long. "he A) is a short-term relationship here. If the economy persists in operating a!ove potential, the A) curve ill shift to the left, making the increases in real output transitory.

5t lo levels of Y, the orld is more complicated. First, most modern industrial economies e+perience fe if any falls in prices. 6o the A) curve is unlikely to shift do n or to the right. 6econd, hen they do suffer price cuts (as in Japan), it can lead to disastrous deflation. 7edit8

Mar*#an cr#t#+ue
In Mar+ian economics, the e*uation of aggregate demand ith e+penditure on ',/ is re.ected as false, on conceptual and statistical grounds. Firstly, ',/ as a measure of value added e+cludes purchases of all intermediate goods used up in production. 6econdly, 'ross ?utput from hich ',/ is derived !y deducting intermediate e+penditures, encompasses only those flo s of income or e+penditure regarded as related to production. Property income in the form of certain types of interest, transfers, land rents and realised capital gains from asset sales are e+cluded from gross output and ',/. "herefore, if the amount of property income (or transfers) increases, although ',/ remains constant, national income receipts can nevertheless increase, and conse*uently aggregate demand can also increase. "hirdly, 'ross fi+ed capital formation measures only investment in productive fi+ed assets and does not constitute total investment, hich includes also purchases of financial assets. Fourthly, ',/ in principle e+cludes sales of second2hand assets e+cept for those modified !y some prior productive activity (e.g. reconditioned cars). Finally, e+penditure on ',/ o!viously disregards the creation of credit money !y !anks and governments, hich !oosts aggregate demand. "hus, it is argued, the catch2all 4eynesian notion of aggregate demand:

o!scures the distri!ution of income !et een social classes ith different propensities to save, consume and invest, and fails to differentiate appropriately !et een different kinds of investment and consumption e+penditure.

"he implication is that restraining consumption and a higher savings rate does not automatically imply more investment, and lo er investment does not automatically mean higher consumption e+penditure. Funds may (as 4eynes himself ackno ledges) !e hoarded in some form, diverted to lu+ury consumption, used for speculation or spent on arms procurement for e+ample..