Aggregate demand

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In macroeconomics, Aggregate Demand (AD) or Domestic Final Demand (DFD) is the total demand for final goods and services in an economy at a given time. [1] It is often called effective demand, though at other times this term is distinguished. This is the demand for the gross domestic product of a country. It specifies the amounts of goods and services that will be purchased at all possible price levels. [2]

Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies. Macroeconomists study aggregated indicators such as GDP, unemployment rates, national income, price indices, and the interrelations among the different sectors of the economy to better understand how the whole economy functions. They also develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, saving, investment, energy, international trade, and international finance.

In economics, effective demand (ED) in a market is the demand for a product or service which occurs when purchasers are constrained in a different market. It contrasts with notional demand, which is the demand that occurs when purchasers are not constrained in any other market. In the aggregated market for goods in general, demand, notional or effective, is referred to as aggregate demand. The concept of effective supply parallels the concept of effective demand. The concept of effective demand or supply becomes relevant when markets do not continuously maintain equilibrium prices.

Gross domestic product market value of goods and services produced within a country

Gross domestic product (GDP) is a monetary measure of the market value of all the final goods and services produced in a specific time period, often annually. GDP (nominal) per capita does not, however, reflect differences in the cost of living and the inflation rates of the countries; therefore using a basis of GDP per capita at purchasing power parity (PPP) is arguably more useful when comparing differences in living standards between nations.

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The aggregate demand curve is plotted with real output on the horizontal axis and the price level on the vertical axis. It is downward sloping as a result of three distinct effects: Pigou's wealth effect, Keynes' interest rate effect and the Mundell–Fleming exchange-rate effect. The Pigou effect states that a higher price level implies lower real wealth and therefore lower consumption spending, giving a lower quantity of goods demanded in the aggregate. The Keynes effect states that a higher price level implies a lower real money supply and therefore higher interest rates resulting from financial market equilibrium, in turn resulting in lower investment spending on new physical capital and hence a lower quantity of goods being demanded in the aggregate.

Real gross domestic product is a macroeconomic measure of the value of economic output adjusted for price changes. This adjustment transforms the money-value measure, nominal GDP, into an index for quantity of total output. Although GDP is total output, it is primarily useful because it closely approximates the total spending: the sum of consumer spending, investment made by industry, excess of exports over imports, and government spending. Due to inflation, GDP increases and does not actually reflect the true growth in an economy. That is why the GDP must be divided by the inflation rate to get the growth of the real GDP. Different organizations use different types of 'Real GDP' measures, for example the United Nations UNCTAD uses 2005 Constant prices and exchange rates while the FRED uses 2009 constant prices and exchange rates, and recently the World Bank switched from 2005 to 2010 constant prices and exchange rates.

The general price level is a hypothetical daily measure of overall prices for some set of goods and services, in an economy or monetary union during a given interval, normalized relative to some base set. Typically, the general price level is approximated with a daily price index, normally the Daily CPI. The general price level can change more than once per day during hyperinflation.

In economics, the Pigou effect is the stimulation of output and employment caused by increasing consumption due to a rise in real balances of wealth, particularly during deflation. The term was named after Arthur Cecil Pigou by Don Patinkin in 1948.

The Mundell–Fleming exchange-rate effect is an extension of the IS–LM model. Whereas the traditional IS-LM Model deals with a closed economy, Mundell–Fleming describes a small open economy. The Mundell–Fleming model portrays the short-run relationship between an economy's nominal exchange rate, interest rate, and output (in contrast to the closed-economy IS–LM model, which focuses only on the relationship between the interest rate and output).

IS–LM model

The IS–LM model, or Hicks–Hansen model, is a macroeconomic tool that shows the relationship between interest rates (ordinate) and assets market. The intersection of the "investment–saving" (IS) and "liquidity preference–money supply" (LM) curves models "general equilibrium" where supposed simultaneous equilibria occur in both the goods and the asset markets. Yet two equivalent interpretations are possible: first, the IS–LM model explains changes in national income when price level is fixed short-run; second, the IS–LM model shows why an aggregate demand curve can shift. Hence, this tool is sometimes used not only to analyse economic fluctuations but also to suggest potential levels for appropriate stabilisation policies.

The aggregate demand curve illustrates the relationship between two factors: the quantity of output that is demanded and the aggregate price level. Aggregate demand is expressed contingent upon a fixed level of the nominal money supply. There are many factors that can shift the AD curve. Rightward shifts result from increases in the money supply, in government expenditure, or in autonomous components of investment or consumption spending, or from decreases in taxes.

In economics, a real value, of a good or other entity, is one which has been adjusted for inflation, enabling comparison of quantities as if prices had not changed. Changes in real terms therefore exclude the effect of inflation. In contrast with a real value, a nominal value has not been adjusted for inflation, and so changes in nominal value reflect at least in part the effect of inflation.

Money supply total amount of monetary assets available in an economy at a specific time

The money supply is the total value of monetary assets available in an economy at a specific time. There are several ways to define "money", but standard measures usually include currency in circulation and demand deposits.

Consumption (economics) purchase and use of goods and services

Consumption, defined as spending for acquisition of utility, is a major concept in economics and is also studied in many other social sciences. It is seen in contrast to investing, which is spending for acquisition of future income.

According to the aggregate demand-aggregate supply model, when aggregate demand increases, there is movement up along the aggregate supply curve, giving a higher level of prices. [3]

AD–AS model

The AD–AS or aggregate demand–aggregate supply model is a macroeconomic model that explains price level and output through the relationship of aggregate demand and aggregate supply.

Aggregate supply

In economics, Aggregate Supply (AS) or Domestic Final Supply (DFS) is the total supply of goods and services that firms in a national economy plan on selling during a specific time period. It is the total amount of goods and services that firms are willing and able to sell at a given price level in an economy.

History

John Maynard Keynes in The General Theory of Employment, Interest and Money argued during the Great Depression that the loss of output by the private sector as a result of a systemic shock (the Wall Street Crash of 1929) ought to be filled by government spending. First, he argued that with a lower ‘effective aggregate demand’, or the total amount of spending in the economy (lowered in the Crash), the private sector could subsist on a permanently reduced level of activity and involuntary unemployment, unless there were active intervention. Business lost access to capital, so it had dismissed workers. This meant workers had less to spend as consumers, consumers bought less from business, which because of additionally reduced demand, had found the need to dismiss workers. The downward spiral could only be halted and rectified by external action. Second, people with higher incomes have a lower marginal propensity to consume their incomes. People with lower incomes are inclined to spend their earnings immediately to buy housing, food, transport and so forth, while people with much higher incomes cannot consume everything. They save instead, which means that the velocity of money, meaning the circulation of income through different hands in the economy, is decreased. This lowered the rate of growth. Spending should therefore target public works programmes on a large enough scale to speed up growth to its previous levels.

<i>The General Theory of Employment, Interest and Money</i> book by John Maynard Keynes

The General Theory of Employment, Interest and Money of 1936 is the last and most important book by the English economist John Maynard Keynes. It created a profound shift in economic thought, giving macroeconomics a central place in economic theory and contributing much of its terminology – the "Keynesian Revolution". It had equally powerful consequences in economic policy, being interpreted as providing theoretical support for government spending in general, and for budgetary deficits, monetary intervention and counter-cyclical policies in particular. It is pervaded with an air of mistrust for the rationality of free-market decision making.

Great Depression 20th-century worldwide economic depression

The Great Depression was a severe worldwide economic depression that took place mostly during the 1930s, beginning in the United States. The timing of the Great Depression varied across nations; in most countries it started in 1929 and lasted until the late 1930s. It was the longest, deepest, and most widespread depression of the 20th century. In the 21st century, the Great Depression is commonly used as an example of how intensely the world's economy can decline.

Wall Street Crash of 1929 stock market crash of 1929

The Wall Street Crash of 1929, also known as the Stock Market Crash of 1929 or the Great Crash, was a major stock market crash that occurred in late October 1929. It started on October 24 and continued until October 29, 1929, when share prices on the New York Stock Exchange collapsed.

Components

An aggregate demand curve is the sum of individual demand curves for different sectors of the economy. The aggregate demand is usually described as a linear sum of four separable demand sources: [4]

where

These four major parts, which can be stated in either 'nominal' or 'real' terms, are:

In sum, for a single country at a given time, aggregate demand ( or ) is given by .

These macroeconomic variables are constructed from varying types of microeconomic variables from the price of each, so these variables are denominated in (real or nominal) currency terms.

Aggregate demand curves

Understanding of the aggregate demand curve depends on whether it is examined based on changes in demand as income changes, or as price change.

Keynesian cross

Aggregate demand-aggregate supply model

Sometimes, especially in textbooks, "aggregate demand" refers to an entire demand curve that looks like that in a typical Marshallian supply and demand diagram.

Aggregate supply/demand graph AS + AD graph.svg
Aggregate supply/demand graph

Thus, we could refer to an "aggregate quantity demanded" ( in real or inflation-corrected terms) at any given aggregate average price level (such as the GDP deflator), .

In these diagrams, typically the rises as the average price level () falls, as with the line in the diagram. The main theoretical reason for this is that if the nominal money supply (Ms) is constant, a falling implies that the real money supply ()rises, encouraging lower interest rates and higher spending. This is often called the "Keynes effect".

Carefully using ideas from the theory of supply and demand, aggregate supply can help determine the extent to which 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 (at any given ) shifts the curve to the right. This increases both the level of real production () and the average price level ().

But different levels of economic activity imply different mixtures of output and price increases. As shown, with very low levels of real gross domestic product and thus large amounts of unemployed resources, most economists of the Keynesian school suggest that most of the change would be in the form of output and employment increases. As the economy gets close to potential output (), we would see more and more price increases rather than output increases as increases.

Beyond , this gets more intense, so that price increases dominate. Worse, output levels greater than cannot be sustained for long. The is a short-term relationship here. If the economy persists in operating above potential, the curve will shift to the left, making the increases in real output transitory.

At low levels of , the world is more complicated. First, most modern industrial economies experience few if any falls in prices. So the curve is unlikely to shift down or to the right. Second, when they do suffer price cuts (as in Japan), it can lead to disastrous deflation.

Debt

A post-Keynesian theory of aggregate demand emphasizes the role of debt, which it considers a fundamental component of aggregate demand; [5] the contribution of change in debt to aggregate demand is referred to by some as the credit impulse. [6] Aggregate demand is spending, be it on consumption, investment, or other categories. Spending is related to income via:

Income – Spending = Net Savings

Rearranging this yields:

Spending = Income – Net Savings = Income + Net Increase in Debt

In words: What you spend is what you earn, plus what you borrow. If you spend $110 and earned $100, then you must have net borrowed $10. Conversely if you spend $90 and earn $100, then you have net savings of $10, or have reduced debt by $10, for a net change in debt of –$10.

If debt grows or shrinks slowly as a percentage of GDP, its impact on aggregate demand is small. Conversely, if debt is significant, then changes in the dynamics of debt growth can have significant impact on aggregate demand. Change in debt is tied to the level of debt: [5] if the overall debt level is 10% of GDP and 1% of loans are not repaid, this impacts GDP by 1% of 10% = 0.1% of GDP, which is statistical noise. Conversely, if the debt level is 300% of GDP and 1% of loans are not repaid, this impacts GDP by 1% of 300% = 3% of GDP, which is significant: a change of this magnitude will generally cause a recession.

Similarly, changes in the repayment rate (debtors paying down their debts) impact aggregate demand in proportion to the level of debt. Thus, as the level of debt in an economy grows, the economy becomes more sensitive to debt dynamics, and credit bubbles are of macroeconomic concern. Since write-offs and savings rates both spike in recessions, both of which result in shrinkage of credit, the resulting drop in aggregate demand can worsen and perpetuate the recession in a vicious cycle.

This perspective originates in, and is intimately tied to, the debt-deflation theory of Irving Fisher, and the notion of a credit bubble (credit being the flip side of debt), and has been elaborated in the Post-Keynesian school. [5] If the overall level of debt is rising each year, then aggregate demand exceeds Income by that amount. However, if the level of debt stops rising and instead starts falling (if "the bubble bursts"), then aggregate demand falls short of income, by the amount of net savings (largely in the form of debt repayment or debt writing off, such as in bankruptcy). This causes a sudden and sustained drop in aggregate demand, and this shock is argued to be the proximate cause of a class of economic crises, properly financial crises. Indeed, a fall in the level of debt is not necessary – even a slowing in the rate of debt growth causes a drop in aggregate demand (relative to the higher borrowing year). [7] These crises then end when credit starts growing again, either because most or all debts have been repaid or written off, or for other reasons as below.

From the perspective of debt, the Keynesian prescription of government deficit spending in the face of an economic crisis consists of the government net dis-saving (increasing its debt) to compensate for the shortfall in private debt: it replaces private debt with public debt. Other alternatives include seeking to restart the growth of private debt ("reflate the bubble"), or slow or stop its fall; and debt relief, which by lowering or eliminating debt stops credit from contracting (as it cannot fall below zero) and allows debt to either stabilize or grow – this has the further effect of redistributing wealth from creditors (who write off debts) to debtors (whose debts are relieved).

Criticisms

Austrian theorist Henry Hazlitt argued that aggregate demand is "a meaningless concept" in economic analysis. [8] Friedrich Hayek, another Austrian, wrote that Keynes' study of the aggregate relations in an economy is "fallacious", arguing that recessions are caused by micro-economic factors. [9]

See also

Related Research Articles

Demand-pull inflation type of inflation where aggregate demand increases faster than aggregate supply

Demand-pull inflation is asserted to arise when aggregate demand in an economy outpaces aggregate supply. It involves inflation rising as real gross domestic product rises and unemployment falls, as the economy moves along the Phillips curve. This is commonly described as "too much money chasing too few goods." More accurately, it should be described as involving "too much money spent chasing too few goods," since only money that is spent on goods and services can cause inflation. This would not be expected to happen, unless the economy is already at a full employment level. It is the opposite of cost-push inflation.

Inflation increase in the general price level of goods and services in an economy over a period of time

In economics, inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy. The measure of inflation is the inflation rate, the annualized percentage change in a general price index, usually the consumer price index, over time. The opposite of inflation is deflation.

New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of new classical macroeconomics.

In economics, the fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. More generally, the exogenous spending multiplier is the ratio of a change in national income to any autonomous change in spending that causes it. When this multiplier exceeds one, the enhanced effect on national income is called the multiplier effect. The mechanism that can give rise to a multiplier effect is that an initial incremental amount of spending can lead to increased income and hence increased consumption spending, increasing income further and hence further increasing consumption, etc., resulting in an overall increase in national income greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output that is a multiple of the initial change.

In economics, the marginal propensity to consume (MPC) is a metric that quantifies induced consumption, the concept that the increase in personal consumer spending (consumption) occurs with an increase in disposable income. The proportion of disposable income which individuals spend on consumption is known as propensity to consume. MPC is the proportion of additional income that an individual consumes. For example, if a household earns one extra dollar of disposable income, and the marginal propensity to consume is 0.65, then of that dollar, the household will spend 65 cents and save 35 cents. Obviously, the household cannot spend more than the extra dollar.

In economics, crowding out is a phenomenon that occurs when increased government involvement in a sector of the market economy substantially affects the remainder of the market, either on the supply or demand side of the market.

In economics, aggregate expenditure (AE) is a measure of national income. Aggregate expenditure is defined as the current value of all the finished goods and services in the economy. The aggregate expenditure is thus the sum total of all the expenditures undertaken in the economy by the factors during a given time period. It is the expenditure incurred on consumer goods, planned investment and the expenditure made by the government in the economy. In an open economy scenario, aggregate expenditure also includes the difference between the exports and the imports.

Balanced budget Financial plan where revenues equal expenses

A balanced budget is a budget in which revenues are equal to expenditures. Thus, neither a budget deficit nor a budget surplus exists. More generally, it is a budget that has no budget deficit, but could possibly have a budget surplus. A cyclically balanced budget is a budget that is not necessarily balanced year-to-year, but is balanced over the economic cycle, running a surplus in boom years and running a deficit in lean years, with these offsetting over time.

The Mundell–Fleming model, also known as the IS-LM-BoP model, is an economic model first set forth (independently) by Robert Mundell and Marcus Fleming. The model is an extension of the IS-LM model. Whereas the traditional IS-LM model deals with economy under autarky, the Mundell–Fleming model describes a small open economy. Mundell's paper suggests that the model can be applied to Zurich, Brussels and so on.

In monetary economics, the demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits rather than investments. It can refer to the demand for money narrowly defined as M1, or for money in the broader sense of M2 or M3.

In macroeconomics, a multiplier is a factor of proportionality that measures how much an endogenous variable changes in response to a change in some exogenous variable.

Keynesian cross diagram related to economic theory

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Demand-led growth

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Keynes’s theory of wages and prices is contained in the three chapters 19-21 comprising Book V of the General theory. Chapters 20 and 21 are particularly difficult to read, and all three chapters have generally been given a subordinate role in presentations of Keynesian theory.

References

  1. Sexton, Robert; Fortura, Peter (2005). Exploring Economics. ISBN   0-17-641482-7. This is the sum of the demand for all final goods and services in the economy. It can also be seen as the quantity of real GDP demanded at different price levels.
  2. O'Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. p. 307. ISBN   0-13-063085-3.
  3. Mankiw, N. Gregory, and William M. Scarth. Macroeconomics. Canadian ed., 4th ed. New York: Worth Publishers, 2011. Print.
  4. "aggregate demand (AD)". Archived from the original on 9 November 2007. Retrieved 2007-11-04.
  5. 1 2 3 Debtwatch No 41, December 2009: 4 Years of Calling the GFC, Steve Keen, December 1, 2009
  6. Credit and Economic Recovery: Demystifying Phoenix Miracles, Michael Biggs, Thomas Mayer, Andreas Pick, March 15, 2010
  7. "However much you borrow and spend this year, if it is less than last year, it means your spending will go into recession." Dhaval Joshi, RAB Capital, quoted in Noughty boys on trading floor led us into debt-laden fantasy
  8. Hazlitt, Henry (1959). The Failure of the 'New Economics': An Analysis of the Keynesian Fallacies (PDF). D. Van Nostrand.[ page needed ]
  9. Hayek, Friedrich (1989). The Collected Works of F.A. Hayek. University of Chicago Press. p. 202. ISBN   978-0-226-32097-7.