Aggregate demand

Add together everything an economy wants to buy and you have aggregate demand, one half of the framework that explains output and inflation.

Aggregate demand is the total demand for goods and services in an economy at a given overall price level, the sum of what households, firms, government, and foreigners want to buy. It is one of the central concepts of macroeconomics, and the lever that demand-side policy tries to move.

The four sources

Aggregate demand is conventionally split into four components: consumption by households, investment by firms, government spending, and net exports, exports minus imports. Each responds to different forces, consumer confidence and income, business expectations and interest rates, political choices, and foreign demand and exchange rates, and changes in any of them shift total demand. Tracking these components is how economists diagnose where demand is strong or weak.

Why it slopes down

Aggregate demand falls as the overall price level rises, for reasons distinct from those behind a single product's demand curve. A higher price level erodes the real value of money and wealth, makes the country's goods dearer to foreigners, and tends to raise interest rates, each of which dampens spending. The relationship between the price level and total demand is what allows demand and supply to be analysed at the level of the whole economy.

The target of policy

Much of macroeconomic management is, in effect, an attempt to manage aggregate demand. When demand is too weak, output and employment fall, and policy, lower interest rates, more government spending, tries to lift it. When demand outruns the economy's capacity to supply, inflation results, and policy tries to restrain it. The Keynesian tradition in particular places the management of aggregate demand at the centre of stabilising the economy.

Aggregate demand is half of the basic apparatus, with aggregate supply, through which economists understand the economy as a whole. Its components and its sensitivity to prices, confidence, and policy are the starting point for explaining why output and inflation rise and fall, and how governments and central banks try to steer them.