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 amount of goods and services that will be purchased at all possible price levels. [2] Consumer spending, investment, corporate and government expenditure, and net exports make up the aggregate demand.

Contents

The aggregate demand curve is plotted with real output on the horizontal axis and the price level on the vertical axis. While it is theorized to be downward sloping, the Sonnenschein–Mantel–Debreu results show that the slope of the curve cannot be mathematically derived from assumptions about individual rational behavior. [3] [4] Instead, the downward sloping aggregate demand curve is derived with the help of three macroeconomic assumptions about the functioning of markets: 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.

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).

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.

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. [5]

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 average 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.

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: [6]

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 fall 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; [7] the contribution of change in debt to aggregate demand is referred to by some as the credit impulse. [8] 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: [7] 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. [7] 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). [9] 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. [10] 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. [11]

See also

Related Research Articles

Keynesian economics Group of macroeconomic theories

Keynesian economics are the various macroeconomic theories and models of how aggregate demand strongly influences economic output and inflation. In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the economy. Instead, it is influenced by a host of factors – sometimes behaving erratically – affecting production, employment, and inflation.

Macroeconomics Study of an economy as a whole

Macroeconomics is a branch of economics dealing with performance, structure, behavior, and decision-making of an economy as a whole. For example, using interest rates, taxes, and government spending to regulate an economy’s growth and stability. This includes regional, national, and global economies. According to a 2018 assessment by economists Emi Nakamura and Jón Steinsson, economic "evidence regarding the consequences of different macroeconomic policies is still highly imperfect and open to serious criticism."

Inflation Rise in price level in an economy over time

In economics, inflation refers to a general progressive increase in prices of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of money. The opposite of inflation is deflation, a sustained decrease in the general price level of goods and services. The common measure of inflation is the inflation rate, the annualised percentage change in a general price index.

IS–LM model Macroeconomic model relating interest rates and asset market

The IS–LM model, or Hicks–Hansen model, is a two-dimensional macroeconomic tool that shows the relationship between interest rates 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 the price level is fixed in the 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.

Fiscal policy Use of government revenue collection and expenditure to influence a countrys economy

In economics and political science, fiscal policy is the use of government revenue collection and expenditure to influence a country's economy. The use of government revenues and expenditures to influence macroeconomic variables developed as a result of the Great Depression, when the previous laissez-faire approach to economic management became unpopular. Fiscal policy is based on the theories of the British economist John Maynard Keynes, whose Keynesian economics theorized that government changes in the levels of taxation and government spending influences aggregate demand and the level of economic activity. Fiscal and monetary policy are the key strategies used by a country's government and central bank to advance its economic objectives. The combination of these policies enables these authorities to target inflation and to increase employment. Additionally, it is designed to try to keep GDP growth at 2%–3% and the unemployment rate near the natural unemployment rate of 4%–5%. This implies that fiscal policy is used to stabilize the economy over the course of the business cycle.

In economics, the fiscal multiplier is the ratio of change in national income arising from a change in government spending. More generally, the exogenous spending multiplier is the ratio of change in national income arising from any autonomous change in spending. When this multiplier exceeds one, the enhanced effect on national income may be 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.

Government budget balance Difference between revenues and spending

A government budget is a financial statement presenting the government's proposed revenues and spending for a financial year. The government budget balance, also alternatively referred to as general government balance, public budget balance, or public fiscal balance, is the overall difference between government revenues and spending. A positive balance is called a government budget surplus, and a negative balance is a government budget deficit. A budget is prepared for each level of government and takes into account public social security obligations.

<i>The General Theory of Employment, Interest and Money</i> 1936 book by John Maynard Keynes

The General Theory of Employment, Interest and Money of 1936 is a book by English economist John Maynard Keynes. It caused 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.

Consumption (economics) Using money to obtain an item for use

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.

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, 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.

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.

Mundell–Fleming model Economic model

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.

Inflationary gap Amount by which the actual GDP exceeds potential full-employment GDP

An inflationary gap, in economics, is the amount by which the actual gross domestic product (GDP) exceeds potential full-employment GDP. It is one type of output gap, the other being a recessionary gap.

Multiplier (economics)

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.

AD–AS model Macroeconomic model relating aggregate demand and supply

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.

Keynesian cross Formulation of the central ideas in the book The General Theory of Employment, Interest and Money

The Keynesian cross diagram is a formulation of the central ideas in Keynes' General Theory. It first appeared as a central component of macroeconomic theory as it was taught by Paul Samuelson in his textbook, Economics: An Introductory Analysis. The Keynesian Cross plots aggregate income and planned total spending or aggregate expenditure.

Demand-led growth

Demand-led growth is the foundation of an economic theory claiming that an increase in aggregate demand will ultimately cause an increase in total output in the long run. This is based on a hypothetical sequence of events where an increase in demand will, in effect, stimulate an increase in supply. This stands in opposition to the common neo-classical theory that demand follows supply, and consequently, that supply determines growth in the long run.

This glossary of economics is a list of definitions of terms and concepts used in economics, its sub-disciplines, and related fields.

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: Prentice Hall. p. 307. ISBN   0-13-063085-3. Archived from the original on 2016-12-20. Retrieved 2020-11-05.
  3. Sonnenschein, Hugo; Shafer, Wayne (1982). "Market demand and excess demand functions". In Arrow, Kenneth J.; Intriligator, Michael D. (eds.). Handbook of Mathematical Economics. 2. pp. 671–672. The importance of the above results is clear: strong restrictions are needed in order to justify the hypothesis that a market demand function has the characteristics of a consumer demand function. Only in special cases can an economy be expected to act as an ‘idealized consumer.’ The utility hypothesis tells us nothing about market demand unless it is augmented by additional requirements.
  4. Chiappori, Pierre-André; Ekeland, Ivar (1999). "Aggregation and Market Demand: An Exterior Differential Calculus Viewpoint". Econometrica. 67 (6): 1437. doi:10.1111/1468-0262.00085. JSTOR   2999567. ...we establish that when the number of agents is at least equal to the number of goods, then any smooth enough function satisfying Walras's Law can be locally seen as the aggregate market demand of some economy, even when the distribution of income is imposed a priori.
  5. Mankiw, N. Gregory, and William M. Scarth. Macroeconomics. Canadian ed., 4th ed. New York: Worth Publishers, 2011. Print.
  6. "aggregate demand (AD)". Archived from the original on 9 November 2007. Retrieved 2007-11-04.
  7. 1 2 3 Debtwatch No 41, December 2009: 4 Years of Calling the GFC, Steve Keen, December 1, 2009
  8. Credit and Economic Recovery: Demystifying Phoenix Miracles, Michael Biggs, Thomas Mayer, Andreas Pick, March 15, 2010
  9. "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
  10. Hazlitt, Henry (1959). The Failure of the 'New Economics': An Analysis of the Keynesian Fallacies (PDF). D. Van Nostrand.[ page needed ]
  11. Hayek, Friedrich (1989). The Collected Works of F.A. Hayek. University of Chicago Press. p. 202. ISBN   978-0-226-32097-7.