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Aggregate Demand

Components of Aggregate Demand

Terms and Formulae

Problems

Introduction

Aggregate demand tells the quantity of goods and services demanded in an economy at a given price level. In effect, the aggregate demand curve is a just like any other demand curve, but for the sum total of all goods and services in an economy. It tells the total amount that all consumers, businesses, and the government are willing to spend on goods and services at different price levels.

The aggregate demand curve can be thought of just like a demand curve for a firm. When the price level is high, aggregate demand is low; when the price level is low, aggregate demand is high. The aggregate demand curve lies in a plane consisting of the price level and income or output. It shows a downward slope with price level on the vertical axis and income or output on the horizontal axis. As such, the aggregate demand curve outlines the relationship between income or output and the price level. It is important to notice that aggregate demand is a schedule because as the price level changes, the income or output also changes.

There are four major components of aggregate demand. The equation for aggregate demand, Y = C(Y - T) + I(r) + G + NX(e), tells much about the nature of both aggregate demand and the curve that represents this schedule.

Components of aggregate demand

The equation for aggregate demand proposed by the Mundell-Fleming model of a large open economy is Y = C(Y - T) + I(r) + G + NX(e). Y represents income or output. C(Y - T) represents consumption as a function of disposable income, defined as income less taxes. I(r) represents investment as a function of the interest rate, where an increase in the interest rate decreases investment. G represents government spending, which is predominately unaffected by interest rates. Finally, NX(e) represents net exports, defined as exports less imports as a function of the real exchange rate, where an increase in the real exchange rate decreases net exports. Understanding the details of each component of aggregate demand is an important first step toward understanding aggregate demand.

The first piece of the aggregate demand equation is Y. This represents output or income. Because Y is the total amount of goods and services purchased by consumers, businesses, and the government, taking into account foreign trade, it is necessarily the output for the economy. This number is also the gross domestic product of an economy. Because every unit of output within an economy turns into income for members of the economy, it is reasonable to call output income. More specifically, the output of an economy is the national income for the economy. The per capita income is the national income for the economy divided by the population. This number is useful for comparing the standard of living across countries. All of this information directly results from the aggregate demand equation.

The second piece of the aggregate demand equation is C(Y - T). This signifies that consumption is a function of disposable income. Disposable income is the money that consumers have left to spend after taxes. The function for consumption is aggregated across all consumers and thus is applicable for all incomes and tax brackets. Consumption captures spending by households on goods and services. Examples include purchasing food, movie tickets, and vacations.

The third piece of the aggregate demand equation is I(r). This signifies that investment spending is a function of the real interest rate. That is, as the real interest rate increases, investment spending falls because the cost of borrowing money increases. The real interest rate is simply the nominal interest rate as published in the media corrected for expected inflation. When firms consider investment spending, they routinely take into account the nominal interest rate, inflation, and the real interest rate. Examples of investment spending include machinery, buildings, education, and new housing.

The fourth piece of the aggregate demand equation is G. Government spending encompasses every expenditure made by the government. The total amount of money spent by the government is often surprising. In fact, it is not unusual for government spending to constitute upwards of one third of gross domestic product. The level of government spending is a hotly debated topic as political parties vie for their programs in the annual budget. Examples of government spending include salaries to government employees, defense spending, welfare and social security programs, and foreign aid.

The fifth piece of the aggregate demand equation is NX(e). Net exports are defined as the difference between exports and imports. It is important to recognize that net exports are dependent upon the real exchange rate. As the real exchange rate rises, domestic currency is relatively more valuable and thus the price of domestic goods is relatively more expensive than the price of foreign goods. In this case, exports fall and imports rise, causing net exports to decline. Interestingly, a thriving domestic economy will result in a higher real exchange rate and thus lower net exports. Examples of exports include cars and electronics made in the US and sold Asian countries. Examples of imports include fruits and vegetables grown in New Zealand and sold in the US.

The equation for aggregate demand of Y = C(Y - T) + I(r) + G + NX(e) has now been deciphered. This equation has many meanings such as output, national income, and GDP. It is difficult, or impossible, to think of economic activity that is not represented in the aggregate demand equation. This is the idea of aggregate demand: to capture all economic activity within an economy

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