Aggregate Demand

Microeconomics is the study of supply and demand in local markets, while macroeconomic studies supply and demand in the aggregate, the markets of the entire economy.

The model most often used to model the macro economy in the short run is the aggregate demand-aggregate supply (AD-AS) model. Aggregate demand is the total demand for all final goods and services produced by the economy by all economic agents: consumers, firms, government, plus net foreign demand. Net exports equal the total demand for domestic production by people living outside of the country minus the total demand for foreign production by domestic economic agents.

The aggregate demand curve expresses the inverse relationship between aggregate price levels and real GDP. However, the aggregate demand curve is not the same as the demand curve for specific products or services, although they do seem similar. If the aggregate demand declines, then the demand for most products and services will also decline, but demand for some things may increase. Additionally, there is no substitution effect, since most products and services are affected, including possible substitutions. And while the demand curve for a specific product or service plots the quantity demanded vs. the price, the aggregate demand curve plots general price levels against real GDP.

A schematic diagram illustrating the inverse relationship between real GDP, which also equals aggregate demand, and aggregate price levels.
A schematic diagram illustrating the inverse relationship between real GDP, which also equals aggregate demand, and aggregate price levels. (Since the diagram is schematic, this curve, like many other curves in economics, is often depicted as a straight line, which makes it easier to show show relationships and changes in the diagram.)

Aggregate demand affects real GDP and price levels. Aggregate demand is composed of 4 components: consumer consumption, business investment, government spending, and net exports.

Aggregate Demand = GDP (Y) = C + I + G + NX

Consumption

Consumption is largest component of aggregate demand, equal to about 2/3 of output.

Disposable income is household income minus taxes. Thus, consumption depends on disposable income, expressed by the consumption function:

C = C (Y – T) = C0 + C1 (Y – T)

C0 specifies the level of autonomous consumption, which is consumption that does not depend on disposable income, since autonomous consumption is necessary for survival. C1 is the marginal propensity to consume, which is the percentage of disposable income spent for products and services, and, thus, not saved. Y rrepresents real GDP or aggregate demand,, while T represents taxes, so Y – T is disposable income.

A diagram illustrating the consumption function, how consumption varies with the marginal propensity to consume and disposable income.

Note how the propensity to consume varies with income. At low income levels, all increases in income are spent (#1 in the diagram: C = I), while at higher incomes (#2), consumption is less per unit increase in wealth (C < I). Although this diagram is schematic, it does comport with the fact that, per unit of wealth, wealthier people save more and consume less.

The marginal propensity to consume is also illustrated by the higher economic growth in poorer countries than richer countries. Economies grow much faster in emerging markets because the people have so little to begin with, so the marginal propensity to consume is high, while the marginal propensity to consume is much lower in wealthier nations, which is 1 reason why the growth rate of any economy starts leveling off as the wealth of its citizens increases.

A consumer will consume even if he has no income, since some consumption is necessary for survival. Without income, autonomous consumption is financed by savings or by borrowing against future income. Younger people tend to borrow more, while older people rely more on savings and pensions.

The marginal propensity to consume means that any increase in income will increase consumption, but only in proportion to the marginal propensity to consume, since it is usually less than 1. Likewise, any tax decreases will increase disposable income, and therefore, increase consumption by the marginal propensity to consume multiplied by the increase in disposable income.

The Marginal Propensity to Consume is Inversely Proportional to Wealth

The marginal propensity to consume is often graphed as a straight line, (although both the straight-line and my curve are schematic) meaning that the percentage of income used for consumption does not change with increases in income. I disagree with this depiction, because the marginal utility of money declines with increasing income, reflecting the declining marginal utility of the things that it buys. Thus, as people become richer, they spend less of their money for consumption and more for investment. Autonomous consumption, in my opinion, is nothing more than a 100% marginal propensity to consume, reflecting the poor people's need to spend all their money to pay for essentials.

The government often gives tax breaks to stimulate consumption, which stimulates the economy, but some economists have questioned the effectiveness of these tax breaks. David Ricardo argued in his 1817 book, Principles of Political Economy and Taxation, that there is no difference between giving tax breaks, then borrowing the money, or increasing taxes now, since people will not spend the money from the tax breaks because they know that taxes will increase in the future, so they will not spend the money now, but save it for the later tax increase. I disagree with this Ricardian equivalence of using debt or taxes to finance the government. If people did not spend money because they know they were going to have to pay it back, then no one would ever borrow money, but since they do, this explanation is patently false. However, it is true that only some of the money from tax breaks is spent, and the amount spent is proportional to each person's propensity to consume, which, I believe, is inversely proportional to their wealth.

This inverse proportionality explains why tax breaks to the poor stimulate the economy more than tax breaks to the rich, and if money is taken away from the poor and the middle class — such as by giving the lower classes a smaller tax break or none at all or by decreasing payments to the lower classes, such as decreasing healthcare expenditures, or by lowering Social Security or Medicare payments, which is often done to pay for the tax breaks to the wealthy — then the negative effect of higher taxes or lower payments will greatly exceed any positive effect of giving tax breaks to the wealthy. George W. Bush lowered taxes on the wealthy, but the economy still declined after his inauguration in 2001 until 2003, when debt financing greatly increased. Starting in 2004, credit requirements for loans were relaxed, so many poor and middle-class people were able to get loans to buy houses, or to use their home equity to easily get loans for other purchases, which fueled the boom in real estate and the general economy (thus illustrating the lower classes' higher marginal propensity to consume), only to end badly in 2007. The boom had to end, of course, because debt must be repaid, so consumption declines, and with the multiplier effect, the economy declines even more. When debt is repaid, money flows from poorer debtors to richer creditors, causing the aggregate marginal propensity to consume to decline, and with it, the economy, as evinced by the 2007 - 2009 credit crisis. This further illustrates that the marginal propensity to consume declines with wealth.

On the other hand, both President Clinton and President Obama showed that the rich can be taxed heavily, and the economy can still grow robustly. In fact, under President Clinton, the economy boomed! These recent economic events demonstrate that the marginal propensity to consume is inversely proportional to the wealth of the buyer.

The real interest rate will also affect consumption. Higher rates will have a negative effect on consumption, since people will tend to save more and borrow less; lower rates will increase consumption because people will tend to borrow more and save less. However, because many other factors affect consumption, the link between real interest rates and consumption is tenuous at best. For instance, after the credit crisis of 2007 to 2009, interest rates were very low, but people saved more because they recognized the increased risk of not having sufficient savings when the economy downturns.

Investments

Domestic private investment (I) is the 3rd largest component of aggregate demand, typically 15% of GDP, but can vary significantly from a low during busts to a high during booms. (Remember, that economists define investments as the purchase of new capital goods, used to produce products and services.)

Businesses will increase investments until the marginal product of capital equals marginal cost, i.e., the real interest rate plus depreciation:

MPk = r + δ

Investment is a negative function of the real interest rate, when one goes down, the other goes up. Net investment will depend on the real interest rate minus the depreciation rate of existing capital. Since the rate of depreciation is considered constant, investment becomes a simple function of the real interest rate r:

I = I (r)

The amount invested may also depend on other factors, such as the rate that firms would be willing to invest per unit of time, since some projects, such as building new factories, would take considerable time.

A diagram illustrating the inverse relation between the real interest rate and investment.

Taxes on profits will also lower investments proportionate to the tax rate. Hence, the decision to invest will depend on whether the marginal product of capital multiplied by the tax-free rate at least equals the real interest rate minus the depreciation rate.

(1 – Tax Rate) MPk = r + δ

Government Purchases and Net Exports

Government purchases are major component of aggregate demand. Economists treat this component as a constant, since government purchases depend on political decisions, which are not predictable, but historically, government purchases have composed around 20% of aggregate demand.

Net exports are the smallest component of aggregate demand. For the United States, it is usually less than 5%. The main factor that affects net exports is the foreign exchange rate. The foreign exchange rate will tend toward a purchasing power parity, where the equivalent amount of currencies will buy comparable products and services in different countries; otherwise, arbitrage of products and services in different countries will cause the respective currencies to move toward purchasing power parity. Although, the nominal exchange rate changes frequently in response to the supply and demand for the currencies, prices tend to be sticky, because there are usually costs associated with changing prices of products and because arbitrage takes considerable time to equalize any differences in purchasing power of the 2 currencies.

The downward sloping aggregate demand curve, often depicted schematically as a straight line, plots a general price level of the economy to real GDP. The demand for real GDP is the aggregate demand.

A diagram illustrating the inverse relationship between aggregate demand, equal to real GDP, and general price levels.
Shifts along the aggregate demand curve shows the change in real GDP with changes in price level or vice versa. Only changes in either variable will cause shifts along the demand curve, but other factors can cause shifts in the demand curve, such as changes in consumer or business sediment or from changes in economic policy. Rightward shifts show a higher real GDP level at each price level, while leftward shift shows the opposite: lower real GDP level for each price level.

Aggregate demand increases with lower prices for the same reasons that demand for most products and services increases with lower prices. Products and services become more affordable and consumers enjoy higher surplus because of the lower prices. Additionally, exports become cheaper with respect to imports, thus causing more consumption of domestic goods over foreign goods.

Note, however, that aggregate demand differs from demand for individual products or services, because there is no substitution effect. Aggregate demand is the demand for all products and services offered by the economy, so there is no substitution, except in limited cases where foreign products may offer better value.

Shifts in the Aggregate Demand Curve

A diagram illustrating shifts in the aggregate demand curve, resulting from changes in nonprice factors, such as changes in economic policy, people's level of confidence.
Shifts in the aggregate demand curve are caused by changes in factors oother than price levels.

Factors that shift the AD curve to the right include:

An increase in the money supply also shifts aggregate demand to the rate by reducing the interest rate, thereby stimulating consumer consumption and business investment. Leftward shifts in the AD curve are caused by the inverse of the above factors.

Another major factor that shifts the aggregate demand curve is a redistribution of wealth between the wealthy and the non-wealthy. As stated above, poorer people have a greater marginal propensity to consume, so when they receive more the nation's income, that will increase aggregate demand. On the other hand, when more of the nation's income goes to the wealthy, this decreases aggregate demand. The great recession has demonstrated this. When loan requirements were relaxed during the 2004 to 2007 boom, the poor and the middle class received more money, which they readily spent. Money flowed from richer creditors to poorer debtors, increasing the aggregate marginal propensity to consume. Loan requirements were relaxed because banks were transferring their credit default risk for such loans to buyers of mortgage-backed securities; meanwhile, the banks were earning origination and loan processing fees, so they were incentivized to provide as many loans as possible, which is why many borrowers did not even have to prove that they had the income to pay back the loan. When the real estate bubble burst in 2007, loan requirements became much more stringent, causing aggregate demand to drop precipitously. Nonetheless, the money didn't just disappear. Instead of buying products and services, the debtors had to repay their loans, so now the money was flowing from debtors to creditors, and since creditors are generally richer than debtors, the aggregate marginal propensity to consume is much less, so aggregate demand falls.

Changes in demographics can also shift the AD curve, albeit over a longer time. The young and the old tend to spend more of their income, while middle-aged adults tend to save and invest more.