Aggregate Demand and Supply Explained

Aggregate demand is a concept commonly used in economic. It makes reference to the total value of the expenses in goods and services that economic agents (consumers, businesses, and the government) are willing to buy, for each price level, in a limited period.

Before getting started, it is essential noting the difference between Microeconomic and Macroeconomic.

Microeconomics and Macroeconomics

While microeconomic studies the behavior and interaction between households (consumers) and businesses (producers) through the markets, macroeconomic analyzes the global aspects of the economy (production levels, employment, and a country’s prices).

You could say microeconomic focuses on analyzing the essential unities of the economy, and macroeconomic studies the economy’s global behavior.

Microeconomics

Microeconomics analyzes the behavior of every economic unity (households and businesses) in the markets to try to explain and predict the behavior of the producers and consumers.

Its main goal is to determine the prices of the markets. For that, it analyzes the interactions between the primary unities of decision (households and businesses), based on the offer and demand of a particular good and the prices of it (offer and demand law).

Macroeconomic

Macroeconomic tries to obtain a global vision of a country or geographical area’s situation, using macroeconomic magnitudes (Gross domestic product, unemployment, etc.). Its main goal is obtaining a simplified vision of the economy. For that, it uses multiple aggregate variables (as a sum or an average of distinct variables) because it’s the only way of giving a global vision of the economy.

So, while Microeconomic studies production and a particular good’s prices in a particular market, Macroeconomic studies aggregate production (the average prices of all goods) of the economy on a bigger scale.

In summary, among the studies that are integrated into microeconomics, it’s possible to find production. Due to this, you can determine good’s prices inside a particular market. This results in the offer and demand analysis of said goods. We’re talking about supply and demand of the market of a determinate good.

On the other hand, Macroeconomic aggregates the different goods and markets until they are reduced into a particular generic good that represents the sum of all goods and services that are produced and exchanged in an economy. We’re talking about aggregate supply and aggregate demand of a country’s whole production.

This way, this “generic good” will have a unique demand, the Determinate Demand, and a unique supply, the Determinate Supply.

What is aggregate demand?

Aggregate refers to “total.” Aggregate demand is the essential variable that moves economic activity. It represents the total expense that economic agents are willing to make in a particular country, independently of their nationality, in a fixed period.

As its name suggests, it adds a series of magnitudes, which are part of the aggregated demand’s formula. However, there are other factors that directly affect the outcome of the aggregated demand, which will be explained later.

  • Consumption (C): Here we find all the goods and services that households demand and consume, such as food, wear, vehicles; to summarize, durable and non-durable goods. It’s usually the leading factor regarding Gross domestic product. A high percentage of consumption demonstrates a low degree of development of the country because it means the activity of the other economic agents is low.
  • Capital Investment (I): These are the goods that businesses buy as team goods (buildings, machines, etc.), and production structure (raw material), including household expenses for housing. They’re commonly financed using external resources, meaning its volume is based on the cost of money. A high value of capital investment means the country is growing economically.
  • Government Spending (G): Here, we can organize all the expenses related to state-provided goods and services, without an individual demand.
  • Exports of goods and services (X): Exports are a demand entry.
  • Import of goods and services (M): Imports are a withdrawal of demand.

It’s worth noting that a part of a country’s production is sold to other countries (exports) and that part of the expense that countries make consists of buying goods and services produced in other countries (imports).  The X – M part of aggregate demand’s formula can also be defined as Net Exports.

Therefore, to the sum of Consumption (C), Capital Investment (I), Government Spending (G), it will be necessary to add the value of exports (x) and subtract the value of imports (M), meaning the formula to calculate aggregate demand (AD) would be:

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

It’s worth noting that this is the same formula used for calculating the value of Gross Domestic Product. However, they are not the same. Aggregated demand is a prevision of the goods and services that economic agents are willing to buy, while Gross Domestic Product is the total value of what’s really bought.

What are the factors that affect aggregate demand?

Several factors can affect aggregate demand, some of which are listed below.

Changes in Interest Rates

The increase or decrease in interest rates experience will influence the decisions of consumers and businesses. For instance, low levels of interest rate will reduce the borrowing costs for durable goods, like vehicles or homes.

On the other hand, a higher level of interest rate will increase the borrowing costs. Due to this, expenses usually experience a reduction or keep growing slower, based on the extent of the said increase.

Income and Wealth

When a household’s wealth experiences an increase, the aggregate demand will do so as well. The same fact applies when there is a decrease. When personal savings increase, the demand for goods will be reduced. However, the opposite thing happens when the consumers see the economy positively, so their personal savings will decline.

Changes in Inflation Expectations

For instance, if the USD’s value either falls or rises, the prices of foreign goods will vary (either increase or decrease). However, national goods will increase or decrease their prices in foreign markets. Therefore, aggregate demand will reach higher or lower levels, depending on the situation.

What is aggregate supply?

Aggregate supply is the total quantity of goods and services that businesses are willing to produce and sell at every price level. The aggregate supply curve refers to the unconditional offer of goods and services for every price level in the economy.

Short-run aggregate supply

Short-run aggregate supply refers to the use of the remaining inputs during the production process, depending on if there is a higher demand (or prices), and there is a fixed level of capital.

For instance, in these cases, a company is not able to launch a new factory or implement new technologies in order to improve production. So, the company must rely on the factors of production that already exist, such as more hours for workers or more use of the already owned technology.

Taking into consideration the previous information, we can conclude that some of the factors that affect short-run aggregate supply are the following:

  • The costs of production factors
  • Productivity
  • Nominal salaries

Long-run aggregate supply

Contrary to the previous concept, price levels do not have an effect on aggregate supply in the long-run. The only factors that affect it are efficiency and any improvement that occurs regarding productivity.

For instance, some of the mentioned improvements include higher skill and education levels within the personnel, better technology, and income increase. According to the Keynesian theory, long-run aggregate supply is still affected by the price until a particular point is reached. After that, supply becomes unaffected by any change that happens regarding price.

Macroeconomic equilibrium

Macroeconomic equilibrium is a market situation where Aggregated Demand is equal to the Aggregated Supply. Therefore, there will be macroeconomic equilibrium when a general level of prices and a production volume that satisfy all businesses and consumers’ expectations exist.

There are two different perspectives from which macroeconomic equilibrium can be explained:

  • Short-term macroeconomic equilibrium,
  • And long-term macroeconomic equilibrium.

Short-term macroeconomic equilibrium is produced when the aggregated production offered equals the demanded production.

Long-term macroeconomic equilibrium is produced when aggregated production is equal to the potential production or potential domestic income.

Conclusion

In the long term, with an increase of aggregated demand economy will automatically regulate.

By using a particular price level, aggregated demand represents the total expense that economic agents are willing to make, independently if they’re national or foreign.

It’s important to talk about the curves of aggregated supply and aggregated demand because, in both indexes, all individual supplies and demands of all economic agents that act within a country will appear summed or aggregated. These variables do not explain how an isolated market works, like the individual curves of supply and demand, but how the economy functions as a whole group.

Like it happens with individual demand, aggregated demand increases when the prices decrease, and vice versa. On the other hand, when the level of prices increases, the aggregated demand will decrease because there will be a reduction in goods and services that can be acquired with the same money.

So, we can say that prices are the primary variable that determines what the economic agents demand.

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