What Creates Aggregate Demand?

6 Determinants and 5 Components of Aggregate Demand

The aggregate demand curve says that GDP will contract when prices rise.

Definition: Aggregate demand is the overall demand for all goods and services in an entire 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. Therefore, aggregate demand equals the gross domestic product of that economy.

It follows the law of demand that says people will want more good and services when prices fall.

That assumes the other things that drive demand don't change. Economists call this ceteris paribus, or all other things being equal. It means that the other five determinants of demand stay the same. They are income, prices of related goods or services (whether complementary or substitutes), tastes, and expectations. The sixth determinant that affects just aggregate demand is the number of buyers in the economy.

The aggregate demand curve shows the quantity demanded at each price. 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 aggregate demand curve shows how a country's demand changes in response to all prices. You can see this in the aggregate demand curve above.

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 spending on 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 just shifts demand from one group (taxpayers) to another (beneficiaries).
  • Exports. 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)

How to Calculate Aggregate Demand Using the United States as an Example

U.S. aggregate demand was $18.556 trillion in 2016. Fortunately, this formula for aggregate demand is the same as the one used by the Bureau of Economic Analysis to measure GDP. Here's how to calculate it. Use Table 1.1.5 GDP.

  • C = Personal Consumption Expenditures of $12.75 trillion.
  • I = Gross Private Domestic Investment of $3.04 trillion.
  • G = Government Consumption Expenditures of $3.28 trillion.
  • (X-M) = Net Exports of Goods and Services of -$.50 billion.

    Add them together you get $18.556 trillion. (Source: BEA, GDP and Personal Income Accounts, Table 1.1.5.)

    Why the U.S. Imports So Much

    The key 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. Here's how it works. 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 Easy It Is for U.S. Demand to Decline

    Since demand is dependent on personal income and wealth, a decline in either lowers demand. Even before the 2008 financial crisis, the median net worth per family rose only 1.5 percent from 2001 to 2004 according to a Federal Reserve report. Since net worth did not keep up with inflation during these years, the average household felt poorer.

    To meet demand, families took advantage of low-interest home equity loans. As a result, overall debt servicing took a larger percent of household income. In fact, the number of late payments (60+ days) increased, in particular among the bottom 80 percent of the income distribution. When housing prices fell, home equity dried up. Some homeowners walked away, while others lost their homes when they lost their jobs.

    As a result, consumer debt levels fell. A combination of less wealth, lower income and reduced debt weakened U.S. demand. As measured by GDP, demand fell 0.3 percent in 2008.  For more detail, see 2008 GDP Statistics 

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