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What is Aggregate Demand? Research Team | Posted On Thursday, January 22,2009, 06:46 PM

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What is Aggregate Demand?




Aggregate Demand (AD) is the total demand for all of a nation’s goods and services at a given time and price level. AD is usually described as a linear sum of four separable demand sources.

AD = C + I + G + (X-M)

C is consumption,
I is Investment,
G is Government spending,
NX = X - M is Net export,
X is total exports, and
M is total imports

Consumption – This is what consumers spend on goods and services: This includes demand for consumer durables such as automobiles, houses, televisions, computers & non-durable goods such as food and drinks which are “consumed” and must be re-purchased.

Capital Investment – This is investment spending by companies on capital goods such as raw materials, plants and equipments. Investment also includes spending on working capital such as stocks of finished goods and work in progress.

Government Spending – This is government spending on state-provided goods and services such as roads, railways, airports and ports. Decisions on how much the government will spend each year are affected by developments in the economy and also the changing political priorities of the government. Transfer payments in the form of welfare benefits (e.g. state pensions and unemployment allowances) are sometimes not included in general government spending because they are not a payment to a factor of production for any output produced. They are simply a transfer from one group within the economy (i.e. people in work paying income taxes) to another group (i.e. pensioners drawing their state pension having retired from the labour force, or families on low incomes).

Exports of Goods and Services:

Exports refer to goods and services that we sell to other countries; hence, it leads to outflow of goods but inflow of capital (money).

Imports of goods and services - Imports refer to goods and services that come into the economy for us to consume and enjoy from other countries. This leads to flow of money out of the economy.

Net exports (X-M) are the difference between total exports and imports of goods and services. It reflects the net effect of international trade on the level of aggregate demand. When net exports are positive, there is a trade surplus (adding to AD) while when net exports are negative, there is a trade deficit (reducing AD). Indian economy is running on trade deficit for a long time now while economies like China and Arab world run on trade surplus.

Gross Domestic Product (GDP)

GDP is Gross Domestic Product of a country. It is defined as the market value of all goods and services produced within the borders of a country during a given time period. A traditional way of measuring GDP is through aggregate demand which states that output is equal to :

  • All the goods and services demanded and produced that went to a final household or capital user (Final AD)
  • All the goods and services produced that did not go to the final user. These unsold goods and services would be added to the nation’s inventories (ΔINV)

Hence, GDP = Final AD + ΔINV

Nominal GDP:

It is a concept that is very much like revenue .Revenue is the product of two things – price and quantity. Let’s say there is a company XYZ which sells pencils. Each pencil costs Rs. 10. Also, let us assume that it sold 100 pencils in 2007. Hence, its revenue in 2007 was Rs. 1000. So when revenue went up from Rs. 1000 to Rs. 1500 in 2008, we really don’t know whether it was due to selling more units of pencils (e.g. Rs. 10 *150 pencils) or higher prices (e.g. Rs. 15*100 pencils) or a combination of both.

A similar message is conveyed by nominal GDP. If a nation’s nominal GDP went up by 5% in a given year, we don’t really know by how much quantity of output went up or by how much prices went up.

Real GDP:

The above problem is solved by real GDP. It is a measure of the quantity or volume of goods produced in the nation in a given period of time.

Real GDP ~ Nominal GDP – Inflation

Potential GDP:

It is the amount of real GDP that could be produced if all resources were fully utilized.

What does GDP measures?

GDP is more than a measure of business activities in a country. Some economists say it has become a relative measure of country economic success as well as social welfare and happiness. For example, if a country X has higher per capita GDP (GDP divided by total population) than that of country Y, it means people in country X are well off than those in country Y. However, I believe this is farther from truth. Both X and Y might have same GDP but in one country income distribution would be more skewed than the other. One country might have higher literacy and lower crime rate than that in others. Also, happiness is very subjective and differs from person to person and culture to culture.

Purchasing Power Parity (PPP):

While comparing GDP of two or more countries, we convert all the GDPs to the same currency, usually US $. PPP is based on law of one price, which states that, in ideally efficient markets, identical goods should have only one price i.e. whether you buy one gm of gold in India or the US, it should have same price. Otherwise, people will take advantage of price difference and make money.

This purchasing power exchange rate equalizes the purchasing power of different currencies in their home countries for a given basket of goods. Using a PPP basis is arguably more useful when comparing differences in living standards on the whole between nations because PPP takes into account the relative cost of living and the inflation rates of different countries, rather than just a nominal gross domestic product (GDP) comparison.

India’s nominal GDP is $1.1 Trillion dollar while in PPP terms it is $4 Trillion.

Factors causing change in AD:

Changes in Expectations
Current spending is affected by anticipated future income, profit, and inflation

The expectations of consumers and businesses can have a powerful effect on planned spending in the economy E.g. expected increases in consumer incomes, wealth or company profits encourage households and firms to spend more – boosting AD. Similarly, higher expected inflation encourages spending now before price increases come into effect - a short term boost to AD. When confidence turns lower, we expect to see an increase in saving and some companies deciding to postpone capital investment projects because of worries over a lack of demand and a fall in the expected rate of profit on investments.

Changes in Monetary Policy i.e. a change in interest rates
(Note : there is more than one interest rate in the economy, although borrowing and savings rates tend to move in the same direction)

An expansionary monetary policy will cause an outward shift of the AD curve. If interest rates fall – this lowers the cost of borrowing and the incentive to save, thereby encouraging consumption. Lower interest rates encourage firms to borrow and invest.

There are time lags between changes in interest rates and the changes on the components of aggregate demand.

Changes in Fiscal Policy
Fiscal Policy refers to changes in government spending, welfare benefits and taxation, and the amount that the government borrows

For example, the Government may increase its expenditure e.g. financed by a higher budget deficit, - this directly increases AD

Income tax affects disposable income e.g. lower rates of income tax raise disposable income and should boost consumption.

An increase in transfer payments raises AD – particularly if welfare recipients spend a high % of the benefits they receive.

Economic events in the international economy
International factors such as the exchange rate and foreign income (e.g. the economic cycle in other countries)

A fall in the value of the Rs. (a depreciation) makes imports expensive and exports cheaper thereby discouraging imports and encouraging exports – the net result should be that India’s AD rises –

An increase in overseas incomes raises demand for exports and therefore Indian AD rises. In contrast a recession in a major export market will lead to a fall in Indian exports and a decrease in aggregate demand.

Changes in household wealth
Wealth refers to the value of assets owned by consumers e.g. houses and shares

A rise in house prices or the value of shares increases consumers’ wealth and allow an increase in borrowing to finance consumption increasing AD. In contrast, a fall in the value of share prices will lead to a decline in household financial wealth and a fall in consumer demand.

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