Aggregate Demand

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Aggregate Demand – Concept

We’ve studied the Law of Demand, we know it is a negative relationship between the price of a commodity and its demand. We also have studied how it affects the consumer and subsequently how a change in the consumer’s behavior encourages a firm to alter its decisions in and around the market. In effect, demand not only sets the tone for supply alone, it also shows how supply of a specific commodity influences demand.

No matter what type of commodity (referring to both; goods and services) we may choose to discuss as economists, a commodity will continue to be demanded as long as it has the power to satisfy the need (or in other words, have utility to a particular consumer or a group of people; goods that may appear luxuries to one group of consumers may for the other group be, bare necessities). The economy of the country, produces, or at the least, makes available such goods and services for all.

Now tilt your head slightly and allow the next paragraph to sink-in.

Goods and services, in total, for a given period (one year, usually) are demanded at prevailing prices in a country, this is known as aggregate demand.

Mathematically, this is

C + I + G – (Net Exports)

Where,

C = consumer spending/expenditure
I = Investments by firms/capitalists
G = Government spending/expenditure
Net Exports = Total Exports minus Total Imports

Now if you look closely at this equation, you’d notice this is no different from the Gross Domestic Product ‘GDP’ equation, demand for your GDP is, in other words, your aggregate demand ‘AD.’

The AD curve shows an inverse relationship between AD and the price level. The AD is assumed left to right because all the components of AD, other than imports, are inversely related to the price level.

The downward slope of the AD curve reflects a 'normal' macro-economic condition of the economy (an economy with generally favorable cross sectional economic indicators) and that in a recession, the AD curve could become vertical.

Understanding the Application of the concept

AD is used to explain how national income is determined. This model is derived from the basic circular flow concept, which is used to explain how income flows between consumers and firms.

C = Consumer spending/expenditure
I = Investments by firms/capitalists
G = Government spending/expenditure
X = Net Exports
S = Savings
T = Tax on income
M = Various dimensions/dynamics

 

Trade, Liquidity and Wealth Effects

Price changes have a number of important effects on aggregate behavior of a consumer and firms. There are three main effects to consider.

The Trade Effect

The first effect, overseas trade, is perhaps the most noticeable. A rise in domestic prices raises the total costs of production, making it harder to find buyers in the global market (at these new higher prices) and imports on the contrary seems a better option viz-a-viz soaring local costs of production, hence exports 'X' are likely to fall on one hand and imports 'M' are rise on the other. This see-saw of rise and fall creates a trade effect; low AD at the higher price level.

The Interest Rate Effect

When the price level increases, consumers and firms need more money to spend so as to continue to purchase commodities they need. This relative shortage of cash linked to a rise in the price level forces some consumers and firms to borrow from banks, which in turn reduces the liquidity levels of banks. In response, banks are likely to raise interest rates as compensation for this lost liquidity along with the country’s central bank raising interest rates as part of its monetary measures to curb inflation. Furthermore, banks also are required by the central banks to maintain a reserve ratio to meet any unexpected increase in demand for cash.

As a result of the lost liquidity, interest rates are forced to rise and both consumer and firms' spending may fall. Hence, AD is lower at the higher price level.

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The Wealth Effect

As financial markets readjust to the higher price level there are effects that eventually pass on to the consumer and firms’ wealth. Higher rates may lead to a reduced activity if not a possible fall in real estate, for example, resulting in negative wealth effect  (by virtue of loss in value of the real estate/property). Likewise, those consumers and firms that rely on income from shares, rising interest rates eventually lead to shrinking corporate profits and lower share values, again creating a negative wealth effect.

A lower price level will, of course, have the inverse effect, it creates a positive wealth effect on AD. When combined, the above effects explain why aggregate demand responds inversely to changes in the price level.

These effects should not be confused with other exogenous affects, which actually, will shift the AD curve.