Aggregate demand: definition and how to calculate it
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Aggregate demand is an economic measure of the total demand for goods and services within an economy. Economists and others can use this to determine whether an economy is experiencing a slowdown into a recession or recovering from one. If you're interested in economics or analysis, understanding aggregate demand can be very useful. In this article, we give an aggregate demand definition, explain how you can calculate it, the factors which can affect it and its limitations.
Aggregate demand: definition
A definition of aggregate demand can help you to better understand it and its potential uses. It's a macroeconomic measure of the total demand in an economy for finished goods and services. Aggregate demand tracks this at a certain price level and for a specific period of time. It, therefore, represents the total amount of money that consumers, businesses and the government have spent on those goods and services. It's related to the gross domestic product (GDP), which is the total value of all an economy's goods and services for a year.
In the long term, aggregate demand and GDP equalise because of their similar calculation methods. They also increase or decrease together. In the short-term, aggregate demand measurements use nominal pricing, which excludes adjustments for inflation. Elements which contribute to this kind of demand include consumer goods, government spending programmes and business expenditures on capital goods and imports.
How to calculate aggregate demand
Knowing how to calculate aggregate demand can help with your understanding of the economy and its current state. Here are some steps to follow if you want to calculate it:
1. Determine total consumer spending
The first step is to identify how much consumers spent on various goods and services. This could include almost anything, from grocery shopping to buying a new car. It's also necessary to identify the time period in which you're interested, such as a year or quarter. For consumer spending and all other elements of demand, it's essential that they're for the same time period.
2. Identify business spending
The next factor is the total amount of money which businesses have spent. This includes all purchases of capital goods and business investments. Examples include business spending on factories and equipment.
3. Find government spending
The money which governments spend on goods and services is another component of aggregate demand. This is because demand for these goods and services must typically exist for members of the population to require them from the government. Examples include healthcare spending and infrastructure.
4. Calculate net exports
A country's net exports or balance of trade (BOT) is the difference between how much it exports and how much it imports. This is a significant component of the country's balance of payments (BOP), which is the total transactions between that country and the rest of the world. You can easily calculate net exports by subtracting total imports from total exports. If the figure is a positive number, this represents a trade surplus and positively contributes to aggregate demand. If the figure is a negative number, this represents a trade deficit and decreases aggregate demand.
5. Apply the formula
Once you have all four components of aggregate demand, you can add them together using the formula. This is a simple sum of all the elements, although a trade deficit can mean a subtraction. The formula is as follows:
aggregate demand = C + I + G +Nx
aggregate demand = consumer spending + private investment + government spending + (exports - imports)
Factors which influence aggregate demand
A lot of components and variables affect aggregate demand, and understanding these can help you to interpret your results and determine why it may be changing over time. Here are some important factors which influence aggregate demand:
Currency exchange rates
If the currency of the country in question fluctuates, this can influence aggregate demand. This is because the value of the currency can affect the ability of a country to import or export goods. For instance, if the value of the pound (GBP) rises, it makes it cheaper to import goods from abroad but more expensive to export. Conversely, if the pound falls in value, this makes it cheaper to export but more expensive to import.
Consequently, a rise in the value of the currency can increase aggregate demand because the country is buying more and selling less. A fall in the currency's value would therefore decrease aggregate demand because the country is selling more and buying less.
The interest rate can influence demand because it can affect spending. A country's central bank typically determines what the interest rate is going to be, often with the goal of influencing spending. When the interest rate is lower, credit becomes cheaper and the return on investments like savings accounts falls. This can encourage more spending, especially for expensive items which consumers often buy on credit, like houses, vehicles and large appliances. Corporations can also finance expenditures more cheaply through credit when interest rates are lower. A lower interest rate can therefore increase demand.
Conversely, a higher interest rate increases the cost of borrowing and makes investments like savings accounts more appealing. Consumers are therefore more likely to save their money and less likely to buy things on credit. The cost of borrowing also discourages credit-financed business activities. A higher interest rate, therefore, decreases aggregate demand.
Inflation is a measure of the increase in the price of goods and services. Its current level and future expectations can therefore affect demand since higher prices typically result in lower demand. It's also a good idea to compare the inflation rate to shifts in incomes. If inflation is at 20% and average incomes increase by 10%, this represents a loss of purchasing power for consumers. If inflation is at 10% but incomes increase by 15% on average, this represents an increase in consumer purchasing power. When inflation outpaces increases in incomes, this can cause a decrease in aggregate demand. If income rises outpace inflation, this causes an increase in aggregate demand. Additionally, the belief among consumers and businesses that inflation might increase in future could discourage spending too.
Significant economic events like major recessions can greatly impact aggregate demand. How this occurs depends on the various factors and causes involved. Since a recession is a decline in economic activity, this almost always means that demand falls with it. This is also because GDP and aggregate demand rise or fall together, and a recession represents a contraction in GDP. Specific factors within the recession can also influence aggregate demand directly.
For instance, if the recession is the product of a collapse of the banking sector, this can severely limit the amount of credit which is available, since the main providers of credit are unable to function as normal. A drop in credit availability, together with economic uncertainty, can cause producers to decrease production. Together with increases in unemployment, this can greatly reduce consumer spending.
Limitations of aggregate demand
Although it can be a useful way of assessing an economy's circumstances, there are some limitations or drawbacks of aggregate demand. Some of these include the following:
Causation: Although it's possible to speculate, it's almost impossible to determine a causal relationship between aggregate demand and economic growth. Some economists may claim that aggregate demand influences GDP, whereas others claim the opposite.
Quality: Aggregate demand uses market values and only considers output at a certain price level. This omits factors like living standards or the quality of the goods and services within the economy.
Variables: Although it only contains four elements in the formula, the variables which can affect these are numerous and often interrelated. This can make it very difficult to determine the cause of a shift in aggregate demand.
Policy: Government policies can affect aggregate demand or the various factors which contribute to it. Unlike measurements like interest rates, it's almost impossible to quantify government policies and therefore determine their effects on demand.
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