Aggregate Demand, Its Components, and How to Calculate It

Six Determinants and Five Components of Aggregate Demand

GDP
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Aggregate demand is how many goods and services people buy. It's usually reported for a specific time period, such as month, quarter, or year.

Demand changes as the price increases. That's called the law of demand. It says people will want more goods and services when prices fall. They will buy less as prices increase.

Ceteris paribus is an economic term that means all other things being equal.

The law of demand assumes the other determinants of demand don't change. 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.

Key Takeaways

  • Aggregate demand is the demand for all goods and services in an economy.
  • The law of demand says people will buy more when prices fall.
  • The demand curve measures the quantity demanded at each price.
  • The five components of aggregate demand are consumer spending, business spending, government spending, and exports minus imports.
  • The aggregate demand formula is AD = C + I + G +(X-M).

Aggregate Demand Curve

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.

Aggregate-Demand-Curve.png
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. 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.These are the same as the components of GDP.

  1. Consumer spending. That's what families spend on final products that aren't used for investment.
  2. Investment spending by business. It only includes purchases of equipment, buildings, and inventory.
  3. 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).
  4. Exports. That's demand from other countries.
  5. Minus imports. They are demands made by U.S. residents that can't be met by domestic production. So, 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)

Calculate U.S. Aggregate Demand

Fortunately, the formula for aggregate demand is the same as the one used by the Bureau of Economic Analysis to measure nominal GDP. In 2019, it was $21.49 trillion.  Here's how to calculate it. Use Table 1.1.5 GDP of the BEA's GDP and Personal Income Accounts.

  • C = Personal Consumption Expenditures of $14.56 trillion.
  • I = Gross Private Domestic Investment of $3.74 trillion.
  • G = Government Consumption Expenditures of $3.75 trillion.
  • (X-M) = Net Exports of Goods and Services of -$0.63 billion.

Add them together and you get $21.42 trillion. 

Why the U.S. Imports So Much

The most critical component of demand is consumer goods and services. Whereas the United States supplies its own services, it imports goods that can be made more efficiently overseas. These include industrial supplies, oil, telecommunication equipment, autos, clothing, and furniture. 

Many experts say that the United States has lost its competitive edge in producing these products, and has become a service-oriented economy.

Demand drives economic growth, and growth drives demand.

As incomes rise, people can buy more. As people buy more, companies can make more, and then pay employees more. The ideal situation is healthy growth with moderate inflation.

How It Affects You

The government makes policy depending on how strong demand is in the country. If demand is low, then the government will try to increase it.

That's when the nation's central bank uses expansionary monetary policy. It lowers interest rates. That decreases the cost of automobile, education, and home loans. Similarly, businesses borrow more to buy equipment and expand their operations. The law of demand tells you that lower costs spur demand and economic growth.

Ideally, monetary policy should work in conjunction with the government's fiscal policy. Government leaders spur demand by reducing taxes or increasing spending on program. That's called expansionary fiscal policy

Article Sources

  1. Bureau of Economic Analysis. “National Income and Product Accounts Tables," Table 1.1.5. Nominal GDP. Accessed Jan. 30, 2020.