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. 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.
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. 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.
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.
A post-Keynesian theory of aggregate demand emphasizes the role of debt, which it considers a fundamental component of aggregate demand; the contribution of change in debt to aggregate demand is referred to by some as the credit impulse. 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: 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. 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). 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).
Austrian theorist Henry Hazlitt argued that aggregate demand is “a meaningless concept” in economic analysis. 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.
- ^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.
- ^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.
- ^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.
- ^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.
- ^Mankiw, N. Gregory, and William M. Scarth. Macroeconomics. Canadian ed., 4th ed. New York: Worth Publishers, 2011. Print.
- ^“aggregate demand (AD)”. Archived from the original on 9 November 2007. Retrieved 2007-11-04.
- ^ Jump up to:ab c Debtwatch No 41, December 2009: 4 Years of Calling the GFC, Steve Keen, December 1, 2009
- ^Credit and Economic Recovery: Demystifying Phoenix Miracles, Michael Biggs, Thomas Mayer, Andreas Pick, March 15, 2010
- ^“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
- ^Hazlitt, Henry (1959). The Failure of the ‘New Economics’: An Analysis of the Keynesian Fallacies (PDF). D. Van Nostrand.[page needed]
- ^Hayek, Friedrich (1989). The Collected Works of F.A. Hayek. University of Chicago Press. p. 202. ISBN 978-0-226-32097-7