How Aggregate Demand Works

Economic theory is something that you can spend years studying, but you will find that almost every concept you may encounter traces back to the simple understanding of supply and demand. This makes aggregate demand a significant value to economists. When economists make predictions about economic policy, aggregate demand is useful to them as it informs them of consumers' and businesses' strength.

Aggregate demand estimates how much consumers are willing to spend on all of the goods sold in an economy. When we talk about aggregate demand, we discuss the demand for all of the goods in an economy. The aggregate demand (AD) is calculated with the following equation: AD = C + I + G + (X - M). The components of the equation are:

  • C – Consumer spending on goods and services. People are buying things that they want or need.
  • I – Capital investment. Capital is the equipment needed to create consumer goods, such as machinery and the buildings themselves in which products are made. Capital investment is the money spent on company assets.
  • G – Government spending. This represents the government spending money on the things they provide, such as streetlights or healthcare for low-income families.
  • X – Exports. The goods are sold to overseas parties, the demand for these goods is being "injected" into the economy, it does not exist domestically.
  • M – Imports. This value is taken away from X because it represents a "leakage" of domestic demand. When consumers spend money on imports, the money leaves the country's economy and is injected elsewhere.

Examples of Aggregate Demand

In the real world, aggregate demand is affected by many factors. One factor which plays an important role in aggregate demand is consumer expectations surrounding inflation. If consumers are led to believe that prices will rise, they are more likely to buy things. This leads to an increase in aggregate demand in times of inflation or hyperinflation. Economists are wary of looking at aggregate demand to measure the economy's health: although aggregate demand may skyrocket under hyperinflation, the economy is not doing well. The opposite is also true. In times of slow inflation, consumers will spend less.

Another factor of aggregate demand is a change in household income. If the average income of households rises, then household spending will increase, and vice versa. This is for obvious reasons; people have more disposable income when incomes rise. People are likely to buy more of the things they "want" and might even buy the things they "need" excessively. This causes the value of C to increase, leading to an increase in the aggregate demand overall.

The 2008 financial crisis exhibited both of these factors. There was a fall in income and a fall in inflation simultaneously because of firms' closure and slow economic growth. Across the board, spending fell, which meant that aggregate demand decreased significantly.