Aggregate Demand

In an economy, aggregate demand is the total demand for all finished services and goods produced by that economy.

What Is Aggregate Demand?

Aggregate demand refers to the measure of the total demand for all finished goods and services in an economy. It is the total amount of money exchanged for those goods and services at a set price and point in time.

It is the total sum of everything purchased by firms, households, government and foreign buyers via export minus the part of the demand which is satisfied by foreign producers via imports.

How to Calculate Aggregate Demand? 

It is calculated using the formula C + I + G + (X-M), where C is personal consumption, I is investment, G is government purchases, X is exports, and M is imports. Jointly, they make up what is known as the gross domestic product (GDP).

Factors Determining Aggregate Demand, According to Keynesians

According to Keynesian economists, if a firm desires to achieve high levels of investments, and consumers are eager to spend instead of saving, then aggregate demand will increase. However, if consumers are anxious and opt to save while firms are reluctant to invest, aggregate demand will be low.

In general, Keynesians see the flow of spending in terms of leakages and injections. Investment, government spending and exports inject demand. Savings, taxes, and important leak demand from the economy. When demand is low, the government can correct it by injecting more spending or reducing leakage by cutting taxes.

Factors Affecting Aggregate Demand, According to Monetarists

Monetarists view aggregate demand as determined by the amount of money in circulation. According to monetarists, MV = PY, where M is the amount of money, V is the velocity of circulation of money, and P is the aggregate price of output, Y is the aggregate output or real GDP.

The idea behind monetarists’ view is that households use the money to make purchases. The gross value of goods and services purchased is the nominal GDP or PY. At any point in time, households and businesses hold some cash. The velocity is a measure of how fast they turn the cash over to buy more services and goods. Velocity depends on habits and technology, and what is defined as money.

One key advantage of monetarists is that it introduces a price level into aggregate demand. Taking the supply of money and velocity as given, the demand for real output will be higher if the price level is lower. It means that it is possible to draw a downward-sloping aggregate demand curve just like the demand curve drawn in microeconomics.

The IS-LM Model

A synthesis called IS-LM was created in 1937. For a few decades, it was quite popular. In IS-LM, both money supply and the saving-investment balance impact aggregate demand. It introduces the interest rate as a determinant of money velocity. If the government increases spending, which is an injection, it increases interest rates, which increases the velocity of money, so that nominal GDP increases.