Aggregate Demand (Definition, Components) | Interpretation

What is Aggregate Demand (AD)?

Aggregate Demand is the overall total demand of all the goods and the services in the country’s economy and is expressed as a total amount of the money which is exchanged for such goods and services. So it describes the relationship between all the things which are bought within the country with their prices.

Everything that is purchased in the country is the same as everything which is produced in the country, so the aggregate demand of the country is equal to the GDP of that economy. The aggregate demand is calculated using the different components which include Consumer spending, Government spending, Investment spending and the net exports of the country.

Components of the Aggregate Demand

There are five different components of the AD which are as follows:

Consumer Spending – It is the total amount of spending of the families on the final products which are not used for the purpose of the investment.
Investment Spending – The investment includes all those purchases which are made by the companies for producing consumer goods. However, every purchase is not counted for the aggregate demand as the purchase that only replaces the existing item doesn’t add to the demand.
Government Spending – It includes Spending of the Government on the public goods and the social services but does not include the transfer payments, like Social Security, Medicaid, and medical care, etc. because they don’t create any demand.
Exports – It is the total value of foreign countries spending on the goods and services of the home country.
Imports – It is the total value of spending of the home country on the goods and services imported from foreign countries. This will be deducted from the value of exports of the country to arrive at the net exports of the country during the period.

Aggregate Demand Formula

Aggregate Demand = C + I + G + Nx

Where,

AD = Aggregate demand
C = Spending of the consumer on the goods and services.
I = Private investment and the corporate spending on the non-final capital goods
G = Spending of the Government on public goods and social services.
Nx = Net exports i.e., the value of exports minus value of imports.

Example of the Aggregate Demand

Suppose during a year, in the country United States, Personal Consumption Expenditures was $ 15 trillion, Private investment and the corporate spending on the non-final capital goods was $4 trillion, Government Consumption Expenditure was $3 trillion, the value of exports was $ 2 trillion and the value of imports was $1 trillion. Calculate the aggregate demand of the U.S.

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Aggregate Demand = C + I + G + Nx

Where,

AD = Aggregate demand
C = $ 15 trillion
I = $ 4 trillion
G = $ 3 trillion.

Nx = $ 1 trillion ($2 trillion – $1 trillion)

Now,

= C + I + G + Nx
= $ 15 + $ 4 + $ 3 + $ 1 trillion
= $ 23 trillion

Thus the AD of the U.S. during the period is $ 23 trillion.

Advantages

There are several different advantages of the aggregate demand (AD) for the economy of the country. Some of the advantages are as follows:

It helps in knowing the total demand for all the goods and service in the economy during the given period.
It is used by many of the economist and the market analysts for their research.
The Aggregate demand curve helps in knowing the effect of change in prices of the goods or the services in an economy on the demand of the products.

Disadvantages

The different limitations and drawbacks of the aggregate demand (AD) include the following:

The calculation of the aggregate demand does not give the proof that with the increase in the AD there will be growth in the economy. As the calculation of the Gross domestic product and aggregate demand is same, it shows that they only increase concurrently and it does not show about cause and effect.
In the calculation of the aggregate demand, many of the different economic transactions which happen between the millions of the individuals of the country for different purposes are involved, makes it difficult for calculation, variations, run regressions, etc.

Important points

The aggregate demand curve slopes downward from the left to the right. When the prices of the goods or the services increase or decreases then the demand for the product will also either increase or decrease along with the curve. Also, there can be a shift in the curve when there are changes in money supply in the economy, or increase or decrease in the rate of tax applicable in the economy of the country.
As the AD in a country is measured by the market values, so it represents only the total output at the given price level which may not necessarily represent the quality of the things or the standard of living of the people of the country.

Conclusion

Aggregate Demand is the overall total demand for all the goods and the services in the country’s economy. It is a macroeconomic term which describes the relationship between all the things which are bought within the country with their prices.

Like the AD in a country is measured by the market values, so it represents only the total output at a given price level which may not necessarily represent the quality of the things or the standard of living of the people of the country. It is computed by adding expenditure on the goods and services purchased by the consumers, investment, spending by the government and the net exports of the country.