Meaning of aggregate demand

Aggregate demand (AD) is the total planned expenditure on domestically produced final goods and services at each possible general price level during a given period. It covers spending on domestic output; purchases of imports are excluded.

The aggregate demand curve is a curve showing the relationship between the general price level and the quantity of real output demanded, holding all non-price determinants of aggregate demand constant. The vertical axis shows the general price level—an index rather than a currency amount. Real output or real GDP per period appears on the horizontal axis.

The AD curve slopes downwards. When the price level falls, the real purchasing power of financial wealth rises. Interest rates may fall, while domestic output becomes relatively more competitive internationally. As a result, consumption, investment and net exports can rise, increasing the quantity of real output demanded. A higher price level, by contrast, reduces the quantity demanded.

Only a change in the general price level causes a movement along AD. Any change in a non-price determinant shifts the entire curve, so keep the distinction clear.

The expenditure components

Aggregate demand can be written as:

Consumption is household expenditure on domestically produced final goods and services. Investment is firms’ expenditure on capital goods, together with changes in inventories. Buying existing financial assets is different: ownership changes, but there is no direct purchase of newly produced output.

Government spending is government expenditure on currently produced goods and services. Transfer payments aren’t included themselves. They redistribute income rather than pay for current production, so they affect AD only when recipients later spend that income.

Net exports are export expenditure minus import expenditure. Exports bring foreign spending into domestic output. Imports are deducted because they have already been counted within consumption, investment or government spending, even though they were produced abroad.

Other things equal, a rise in any component increases AD. Higher imports reduce net exports, so AD falls.

Consumption

Consumer confidence is households’ degree of optimism about their future income and economic security. When confidence grows, households normally consume more now. Pessimism, by contrast, encourages saving.

Lower interest rates make saving less rewarding and consumer borrowing cheaper, so consumption tends to rise. An increase in household wealth can also support spending, as households feel more able to consume. Lower income taxes raise disposable income and usually increase consumption.

Heavy household indebtedness may hold consumption back because a larger share of income goes towards interest and repayments. If households expect a higher future price level, they may bring purchases forward. Expectations of falling prices can cause them to delay purchases instead.

Investment

When interest rates fall, borrowing becomes cheaper and more projects are expected to generate returns above their financing cost. Investment therefore tends to rise. Strong business confidence has a similar effect: firms expect higher future sales and profits, which encourages them to add capacity.

Better technology may make new capital more productive, stimulating investment. Lower business taxes also increase expected after-tax returns. However, high corporate indebtedness can reduce investment because firms already face repayment commitments or may struggle to obtain additional credit.

Government spending

Political and economic priorities shape government spending. A government may give greater priority to public services, infrastructure or support for economic activity, leading it to spend more. If it is committed to reducing borrowing, it may spend less.

Net exports

When incomes rise among trading partners, their demand for exports usually increases. Changes in the exchange rate affect the relative prices of exports and imports. After adjustment, a depreciation tends to make exports cheaper for foreign buyers and imports more expensive domestically. An appreciation tends to have the opposite effect.

Trade policies matter too. Lower foreign trade barriers may increase exports, while domestic restrictions on imports may reduce imports. The final effect must be analysed rather than simply asserted because retaliation, supply responses and the price responsiveness of demand can affect the outcome.

From a determinant to a shift

When $C$, $I$, $G$ or $X - M$ increases, total planned expenditure rises at every general price level. AD therefore shifts to the right. A decrease shifts it to the left. Make the reasoning clear: identify which determinant changed, link it to the relevant component, then give the direction of the AD shift.

For instance, greater household optimism raises consumption, so AD shifts right. Higher business taxes may lower expected returns and reduce investment, shifting AD left. Faster growth in export markets may increase exports and shift AD right. Each case is a shift rather than a movement along AD because the initial cause isn’t a change in the domestic general price level.

On the diagram, label both curves and show the direction of the shift. Keep the axes labelled “general price level” and “real output”. A rightward shift shows that more real output is demanded at every price level. By itself, though, it doesn’t prove how much equilibrium output will rise; that also depends on aggregate supply.

The SRAS curve

Aggregate supply (AS) is the total real output that domestic producers are willing and able to supply at each general price level during a given period.

Short-run aggregate supply (SRAS) is the total real output firms are willing and able to produce at each general price level while some input prices, especially nominal wages, adjust slowly. The SRAS curve slopes upwards. When product prices rise faster than relatively fixed input costs, firms earn more profit from production, so they increase real output. As output expands, bottlenecks develop and marginal costs rise, making each further increase in production progressively more costly.

Determinants

Firms’ unit cost of production is the central determinant. If wages, energy prices, raw-material prices or other factor costs rise, firms are prepared to supply less output at each price level. A fall in factor costs has the opposite effect.

An indirect tax is a compulsory payment imposed on expenditure or production rather than directly on income or wealth. Raising an indirect tax increases firms’ production costs and reduces SRAS. Lowering it cuts costs and increases SRAS.

Cost changes and SRAS

When firms’ costs fall, SRAS shifts right because firms supply more real output at each general price level. Higher costs shift SRAS left. These movements can also be described as downward and upward shifts respectively, though “right” and “left” are usually clearer.

Falling energy prices, for instance, reduce production and transport costs, so SRAS shifts right. If nominal wages rise widely without matching productivity growth, unit labour costs increase and SRAS shifts left. Higher indirect taxes also shift SRAS left.

Don’t mistake a change in the general price level for a shift. It causes movement along the existing SRAS curve. For SRAS to shift, a cost or another supply condition must change independently of the general price level.

Monetarist/new classical LRAS

Long-run aggregate supply (LRAS) is the economy’s sustainable real output at each general price level after input prices have fully adjusted. In the monetarist/new classical model, wages and other factor prices become flexible in the long run. LRAS is therefore vertical at potential output. A change in AD may alter the price level, but it cannot keep real output above the economy’s productive capacity permanently.

Potential output is the sustainable level of real output produced when the economy is at full employment. This doesn’t imply zero unemployment. The natural rate of unemployment is the unemployment remaining at full employment because of normal labour-market factors rather than deficient aggregate demand.

Keynesian aggregate supply

The Keynesian AS curve has three sections. Spare capacity changes at different levels of output, while wages and prices are relatively inflexible downwards.

• On the horizontal section, many resources remain unused, so output can rise with little or no increase in the general price level.
• On the upward-sloping section, shortages and bottlenecks begin to affect some industries. An increase in AD raises both real output and the price level.
• At potential output, productive capacity has been reached and the curve becomes vertical. Any further increase in AD raises only the price level.

Output gaps

An inflationary gap is the amount by which equilibrium real output exceeds potential output. It puts pressure on resources, wages and prices. In the monetarist/new classical model, this can occur only in the short run.

A deflationary or recessionary gap is the amount by which potential output exceeds equilibrium real output. In this situation, resources are underused and cyclical unemployment is present. The word “deflationary” describes the gap; the price level need not be falling.

Expanding productive capacity

An increase in potential output appears as a rightward shift of monetarist/new classical LRAS. In the Keynesian model, it shifts the whole AS curve to the right. Either curve can move because of the same supply-side changes:

• Quantity of factors of production: capacity expands when the labour force grows, capital accumulates or usable natural resources are discovered.
• Quality of factors of production: education, training and better health can make labour more productive, while improved capital increases productive capability.
• Technology: improved production methods produce more output from a given quantity of inputs.
• Efficiency: better organization, infrastructure or resource allocation cuts waste and raises output from existing factors.
• Institutions: productive activity can benefit from secure property rights, effective legal systems, well-designed regulation and reliable public administration. If institutions deteriorate, long-term AS can shift left.

These are long-term changes in supply, rather than movements along an AS curve. When potential output increases, vertical LRAS shifts to the right. In the Keynesian model, the capacity limit moves right, along with the horizontal and upward-sloping portions of the curve.

Short-run equilibrium

Macroeconomic equilibrium is a position where aggregate demand equals aggregate supply, so planned total expenditure is consistent with planned total production. For the monetarist/new classical model, short-run equilibrium is found where AD intersects SRAS. This point sets equilibrium real output and the general price level.

When AD shifts right along an upward-sloping SRAS curve, both real output and the price level rise in the short run. A shift to the left lowers both. SRAS shifts produce a different result. For example, a leftward shift of SRAS reduces real output but raises the price level.

Monetarist/new classical long-run equilibrium

The economy reaches long-run equilibrium where AD, SRAS and vertical LRAS intersect at potential output. At that point, unemployment equals the natural rate of unemployment.

A fall in AD may push short-run equilibrium below potential output and create a recessionary gap. Surplus labour and other resources then put downward pressure on nominal wages and input prices. As costs fall, SRAS shifts right until equilibrium returns to potential output at a lower price level.

If AD rises enough to push short-run output above potential, scarce labour and other inputs create upward pressure on wages and factor prices. Production costs rise, shifting SRAS left until output returns to potential at a higher price level. In either case, SRAS adjusts automatically—not LRAS—and restores full-employment equilibrium.

Keynesian equilibrium

In the Keynesian model, equilibrium can occur at any point where AD intersects Keynesian AS. Nominal wages and prices may not fall easily, so equilibrium below potential output doesn’t necessarily cause enough of a rightward AS adjustment. The recessionary gap may persist, leaving real output below potential and unemployment above its full-employment level.

Contrasting assumptions

Both models agree that AD slopes downward. They differ, though, in how factor prices and output respond.

In the monetarist/new classical model, wages and other factor prices are flexible in the long run. Competitive market signals return the economy to potential output. Because LRAS is vertical, changes on the demand side affect real output only temporarily, although they can alter the long-run price level.

The Keynesian model allows for substantial spare capacity and assumes that nominal wages and prices are inflexible downwards. Employment contracts, minimum wages and trade-union resistance may block downward adjustment. So can concerns about worker morale or firms’ reluctance to cut posted prices. As a result, AD has a strong influence on equilibrium output, which may remain below potential output.

Policy implications

Monetarist/new classical economists argue that discretionary demand management may be unnecessary or destabilizing. The economy tends to correct itself, while policy takes time to work. Policies that improve the quantity or quality of factors, technology, efficiency or institutions are more likely to increase potential output without simply raising the price level.

Keynesians take a different view. Waiting for wages and prices to fall may lead to a prolonged recession with persistent unemployment. When substantial spare capacity exists, government action that raises AD can move the economy toward potential output. If the economy is already close to its capacity limit, however, extra AD is more likely to produce inflation than a large increase in real output.

Evaluation of the models

Neither diagram provides a photograph of an economy. Each one isolates a particular mechanism. The monetarist/new classical conclusion relies heavily on wages and prices adjusting both sufficiently and reasonably quickly. In practice, long contracts, debt burdens and resistance to nominal wage cuts can slow that process. During the global financial crisis of 2008–09, many economies faced prolonged weak demand and elevated unemployment. This supports the Keynesian warning that recessionary gaps may persist.

The Keynesian model may understate market adjustment, as well as the risks created by policy delays. Governments might estimate the size of an output gap inaccurately, introduce spending too late or face borrowing constraints. After pandemic restrictions eased, the strong recovery in labour demand across several economies also showed that output and employment can rebound when markets reopen. At the same time, the accompanying bottlenecks demonstrated why extra demand may become inflationary near capacity.

Which account is more persuasive depends on the context. The Keynesian model fits better when spare capacity is large and wages are sticky. Monetarist/new classical reasoning carries more weight over longer periods and where prices and resources are highly flexible. Real economies may show both mechanisms, so policy should reflect the size of the output gap, the source of the disturbance, the speed of adjustment, inflation risk and the state’s ability to intervene effectively.