Aggregate demand is the overall demand for all goods and services in an economy. It’s a macroeconomic term that describes the relationship between everything bought within a country and prices. Everything purchased in a country is the same thing as everything produced in a country. As a result, aggregate demand equals the gross domestic product of that economy.
The law of demand says people will want more good and services when prices fall. That assumes the other determinants of demand don’t change. Economists call this ceteris paribus, or all other things being equal. The other determinants are income, prices of related goods or services (whether complementary or substitutes), tastes, and expectations. The sixth determinant that only affects aggregate demand is the number of buyers in the economy.
The aggregate demand curve shows the quantity demanded at each price. It’s used to show how a country’s demand changes in response to all prices. It’s similar to the demand curve used in microeconomics. That shows how the quantity of one good or service changes in response to price. The relationship between price and demand is illustrated in the aggregate demand curve below.
The aggregate demand curve says that real GDP will decline when prices rise.
Five Components of Aggregate Demand
There are five components of aggregate demand. These are the same as the components of GDP.
- Consumer spending: That’s what families spend on final products that aren’t used for investment.
- Investment spending by business: It only includes purchases of equipment, buildings, and inventory.
- Government spending on goods and services: It does not include transfer payments, such as Social Security, Medicare, and Medicaid. They aren’t included because they don’t increase demand. These programs shift demand from one group (taxpayers) to another (beneficiaries).
- That’s demand from other countries.
- Minus imports: They are demands made by U.S. residents that can’t be met by domestic production. Therefore, the demand leaves the economic system of the United States.
Aggregate Demand Formula
Aggregate demand is measured by the following mathematical formula.
AD = C + I + G +(X-M)
It describes the relationship between demand and its five components.
Aggregate Demand = Consumer Spending + Investment Spending + Government Spending + (Exports-Imports)