Just as demand may be defined as a desire as well as the capacity to obtain goods or services, aggregate demand may be defined as a measure of the total desire and ability of consumers to purchase goods and services in a given economy.However, aggregate demand operates at the macroeconomic level, and it is one of the most crucial elements of macroeconomics. It stands as one estimate of the Gross Domestic Product (GDP) of a given economy and it is good a measure of the total expenditure made on all goods and services in the economy over a period of time.
This aggregate demand also gauges demand over a range of prices, so that it gives an all-inclusive view of the economy from the demand side. Aggregate demand is very closely related to aggregate expenditure, and according to the Keynesian model, they are one and the same.Like the demand curve, the graphical representation of aggregate demand denotes a correlation between price and output. However, price is represented by an index that gives information not about the price of any one commodity or service, but about the general price level that prevails in the economy.
Likewise, output is represented by the general level of real output and not the quantity of any one commodity produced.Changes in demand come about for three main reasons, which are known as The Real Balance Effect, the Interest Rate Effect, and the Net Export Effect (Kaplan). The Real Balance is also called the Wealth Effect (Stanford) and hinges on the purchasing power of the money that consumers have in their possession. This is affected by changes in price, so that when prices increase consumers are able to buy fewer things with their money. This is reflected in a decrease in aggregate demand. Conversely, when prices decrease, consumers increase their spending, increasing aggregate demand.
The Interest Rate Effect reflects a positive relationship between price level and interest rates. An increase in interest rates usually accompanies price increases in order that lenders might compensate for the loss of monetary spending power that comes with increased inflation.When interest rates increase, consumers are less inclined to purchase those commodities that generally require large loans, such as cars and houses. This is reflected in an overall decrease in aggregate demand. When the opposite occurs (i.
e. decreased interest rates and increased borrowing for large investments) then aggregate demand increases.The Net Export Effect is also known as the Trade Balance Effect (Stanford) and this hinges upon the relationship between the prices of domestic and foreign goods. This relationship is an inverse one, so that a fall in relative prices of foreign goods occurs should domestic prices increase.This would lead to an increase in demand for the imported goods at the expense of those produced domestically.
This, therefore, will be reflected as a decrease in aggregate demand. The converse is also true.
