Concept of Aggregate Demand

When we combine the monetary value of all the final goods and services, it is called Gross Domestic Product or GDP. The demand for all such final goods and services is called aggregate demand. On the same note, supply of all such final goods and services is called “aggregate supply”.

• When the aggregate demand represented by a curve, it is known as aggregate demand curve.
• When the aggregate supply is represented by a curve, it is known as aggregate supply curve.

Individual Demand Curve

One of the basic laws of economics is demand curve. A demand curve for an individual normal goods ^{(as some exceptions are there of law of demand such as Giffin Goods)} is downward slopping. This downward slopping demand curve says that when the price of a commodity increases, its demand goes down and vice versa as shown below:

The above curve is downward slopping because of few reasons. The primary reason is that for normal goods, the price and quantity demanded work in opposite direction. As the price of a commodity decreases, the quantity demanded increases over a specified period of time and vice versa. But here, we assume that other things such as prices of related commodities, income etc. remain constant. This slope can also be explained on the basis of three more fundamental reasons as follows:

Law of diminishing marginal utility

This law says that when a consumer purchases more units of a commodity, its marginal utility declines. Therefore, the consumer will purchase more units of that commodity only if its price falls.

Income Effect

When the price of a commodity decreases, the purchasing power of the household increases. The consumer is now in a position to purchase more commodities with the same income. The demand for a commodity thus increases not only from the existing buyers but also from the new buyers who were earlier unable to purchase at higher price. When at a lower price, there is a greater demand for a commodity by the households; the demand curve is bound to slope downward from left to right.

Substitution effect

The demand curve slopes downward from left to right also because of the substitution effect. For example, if the price of meat falls and the prices of poultry remain constant. Then the households would prefer to purchase meat because it is now relatively cheaper. The increase in demand with a fall in the price of meat will move the demand curve downward from left to right.

Aggregate Demand Curve

The aggregate demand curve represents the total quantity of all goods (and services) demanded by the economy at different price levels. This curve is also a downward sloping to the right curve as shown in the adjacent figure. In this graph, the vertical axis represents the price level of all final goods and services; and the horizontal axis represents the real quantity of all goods and services purchased, which is denoted by Real GDP. This graph denotes that the “general price level” and real GDP work in opposite direction. However, this curve is downward sloping for different reasons that those responsible for individual goods and services.

Firstly, the demand curve for an individual good is drawn under the assumption that the prices of other goods remain constant and the assumption that buyers’ incomes remain constant. So, as the price of good X rises, the demand for good X falls because the relative price of other goods is lower and because buyers’ real incomes will be reduced if they purchase good X at the higher price. But in case of aggregate demand curve, a change in the price level implies that many prices are changing, including the wages paid to workers. As wages change, so do incomes. Thus, it is impossible to assume that prices and incomes remain constant in the construction of the aggregate demand curve. Thus there are different reasons for downward slope of aggregate demand curve. These reasons are:

• Wealth Effect
• Interest Rate Effect
• Net Exports Effect

It would be relevant to discuss these three here for a better understanding of the concept.

Wealth Effect

The curve for aggregate demand is drawn on the assumption that the government holds the supply of money constant. This supply of money represents economy’s wealth at any point of time. When there is a rise in the price level, the purchasing power of the entire wealth or supply of money decreases. So, it is assumed that as buyers become poorer, they reduce their purchases of all goods and services. If the general price level falls, the purchasing power of money grows and buyers become wealthier in true sense as they are able to purchase more goods and services than before. This is called Wealth Effect and provides us one reason for inverse relationship between the price level and real GDP that is reflected in the downward‐sloping demand curve.

Interest Rate Effect

When there is a rise in the general price levels, the households and firms require more money to carry out their transactions. But, the supply of money is fixed. Thus, there is an increased demand for a fixed supply of money. This in turn causes the interest rates to go up. When the interest rates rise, expenditures which are sensitive to rate of interest will decline. This is called interest rate effect and provides another reason for the inverse relationship between the price level and the demand for real GDP.

Net exports effect

When there is a rise in the domestic price level, the foreign goods become relatively cheaper, and domestic goods are relatively more expensive to foreign buyers. This raises demand for imports and decreases the demand for exports decreases. When there is a surge in imports and decrease in exports, the net exports decline. Since, net exports are a component of real GDP, the demand for real GDP declines as net exports decline.

Component of Aggregate Demand

Likewise the components of GDP, the components of Aggregate Demand are also same and shown by same formula:

Aggregate Demand = C+I+G+(X-M), where

• C is consumption
• I is investment
• G is Government spending
• X is exports and M is imports.

The question is if both Aggregate Demand and GDP denoted by same formula, then what is difference between the two.

Difference between GDP and Aggregate Demand (AD)

AD is a demand for real GDP. While GDP is a measurement of a country’s production, AD is simply a way of showing how it is related to price levels. In other words, AD is ex-ante concept whereas GDP is an ex-post concept.

Shift in aggregate demand / supply curves

Changes in aggregate demand are not caused by changes in the price level. Instead, they are caused by any or all of the following:

• Changes in the demand for any of the components of real GDP. If the demand of that component increases, the aggregate demand will also increase.
• Changes in the demand for consumption goods and services
• Changes in investment spending.
• Changes in the government’s demand for goods and services
• Changes in the demand for net exports.

We take an example here. We suppose that due to recession, the consumers were to decrease their spending on all goods and services. Due to this, the aggregate demand curve would shift to the left. Further, if interest rates were to fall so that investors increased their investment spending; the aggregate demand curve would shift to the right. If government were to cut spending to reduce a budget deficit, the aggregate demand curve would shift to the left. If the incomes of foreigners were to rise, enabling them to demand more domestic‐made goods, net exports would increase, and aggregate demand would shift to the right. These are just a few of the many possible ways the aggregate demand curve may shift. None of these explanations, however, has anything to do with changes in the price level.

Importance of Aggregate Demand

As discussed above, AD is ex-ante concept whereas GDP is an ex-post concept. The economists are able to forecast the trend in the economy on the basis of aggregate demand and supply data. Further, the government is able to define its policy on the basis of shift in the aggregate demand / supply curves.

The overall objective of the government is to boost Aggregate Demand, which is vital for revival of the economic growth.  The survey notes that the Aggregate demand registered a growth of 5.0 per cent in 2013-14 as against 4.7 per cent in 2012-13 primarily due to improvement in net exports.

Various Factors affecting Aggregate Demand Curve

Exchange Rates

An increase in exchange rate would make domestic currency dearer in terms of foreign currency. When a country’s exchange rate increases, then net exports will decrease and aggregate expenditure will go down at all prices. This means that AD will decrease.

Distribution of Income

When the wages and profits increase, people have more money in their hand. They tend to consume more causing the consumption expenditures to increase. This will boost aggregate demand.

Government Monetary and Fiscal Policy

To boost aggregate demand, the government can follow an expansionary fiscal policy i.e. increase expenditure and reduce taxes. This can also be done by providing monetary or fiscal stimulus during recession.

It can also use a contractionary monetary policy causes AD to decrease.

We take an example here:

During the Global Financial Crisis, the Indian Economy was provided with the monetary stimulus as well as the fiscal stimulus. The result was that the growth rate (Factor Cost at 2004-05 Prices) of the economy was 8.6 and 9.3% in 2009-10 and 2010-11. The stimuli so provided, gave a boost to the demand. Boost to demand results in boost to consumption.

Monetary Stimulus and Fiscal Stimulus

Monetary stimulus involves the manipulation of the available money supply within the economy. Monetary stimulus includes lowering down the key policy rates by RBI and altering the reserve ratios. Lowering interest rates will encourage borrowing and more flow of money in economy. Lower the Reserve ratio, more money the institutions can flow out in market.  Fiscal Stimulus on the other hand means “Increased Government Spending” in Infrastructure etc (with the objective of creating more jobs) and “Higher Tax Cuts” (with the objective increasing the purchasing power of people).

But the after-effect was that this stimulus led to a condition of too much money in the system and it started showing inflationary tendencies.  To curb inflation, RBI started increasing the key policy rates on regular basis. The high rates adversely affected the investment and the result was slow down in the growth rate.