In
Keynesian economics, not all of gross private domestic investment counts as part
of aggregate demand. Much or most of the investment in inventories can be due
to a short-fall in demand (unplanned inventory accumulation or "general over-production").
(Inventory accumulation would correspond to an excess supply of products; in the
National Income and Product Accounts, it is treated as a purchase by its producer.)
Thus, only the planned or intended or desired part of investment (Ip) is counted
as part of aggregate demand.
In
sum, for a single country at a given time, aggregate demand (D or AD) = C + Ip
+ G + NX.
Two
Concepts of the "Aggregate Demand Curve"
One's
concept of the aggregate demand curve depends on whether one examines changes
in demand as income changes or as prices change.
Keynesian
Cross
In
the "Keynesian cross diagram," a desired total spending (or "aggregate
demand") curve is often drawn as a rising level of D as total national output
and income rise. This increase is due to the positive relationship between C and
consumers' disposable income in the consumption function. It may also rise due
to increases in investment (due to the accelerator effect), while this rise is
reduced if imports and tax revenues rise with income. Equilibrium in this diagram
occurs where total spending (D) equals the total amount of national income (which
corresponds to total national output or production). Here, total demand equals
total supply.
In
the diagram, the equilibrium level of output, income, and demand is determined
where this desired spending curve intersects the "Z curve," a line that
represents the equality of total income and output. This is at point E, determining
the equilibrium levels of output and income on the horizontal axis (where the
arrow points).
The
movement toward equilibrium is mostly via changes in inventories inducing changes
in production and income. If current output exceeds the equilibrium, inventories
accumulate, encouraging businesses to cut back on production, moving the economy
toward equilibrium. Similarly, if the level of production is below the equilibrium,
then inventories run down, encouraging an increase in production and thus a move
toward equilibrium. This equilibration process occurs when the equilibrium is
stable, i.e., when the D line is flatter than the Z line.
The
equilibrium level of output determines the equilibrium level of employment in
the model. (In a dynamic view, these are connected by Okun's Law.) There is no
reason within the model why the equilibrium level of employment should correspond
to full employment. Bringing in other considerations may imply this correspondence,
though.
If
any of the components of aggregate demand (C + Ip + G + NX) rises at each level
of income, for example because business becomes more optimistic about future profitability,
that shifts the entire D line upward. This raises equilibrium income and output.
Similarly, if the elements of D fall, that shifts the line downward and lowers
equilibrium output. (The Z line does not shift under the definition used here.)
Marshallian
Cross
Sometimes,
especially in textbooks, "aggregate demand" refers to an entire demand
curve that looks like that in a typical Marshallian supply and demand diagram.
Thus,
that we could refer to an "aggregate quantity demanded" (Yd = C + Ip
+ G + NX in real or inflation-corrected terms) at any given aggregate average
price level (such as the GDP deflator), P.
In
these diagrams, typically the Yd rises as the average price level (P) falls, as
with the AD line in the diagram. The main theoretical reason for this is that
if the nominal money supply (Ms) is constant, a falling P implies that the real
money supply (Ms/P)rises, encouraging lower interest rates and higher spending.
This is often called the "Keynes effect."
Carefully
using ideas from the theory of supply and demand, aggregate supply can help determine
the extent to which increases in aggregate demand lead to increases in real output
or instead to increases in prices (inflation). In the diagram, an increase in
any of the components of AD (at any given P) shifts the AD curve to the right.
This increases both the level of real production (Y) and the average price level
(P).
But
different levels of economic activity imply different mixtures of output and price
increases. As shown, with very low levels of real gross domestic product and thus
large amounts of unemployed resources, most economists of the Keynesian school
suggest that most of the change would be in the form of output and employment
increases. As the economy gets close to potential output (Y*), we would see more
and more price increases rather than output increases as AD increases.
Beyond
Y*, this gets more intense, so that price increases dominate. Worse, output levels
greater than Y* cannot be sustained for long. The AS is a short-term relationship
here. If the economy persists in operating above potential, the AS curve will
shift to the left, making the increases in real output transitory.
At
low levels of Y, the world is more complicated. First, most modern industrial
economies experience few if any falls in prices. So the AS curve is unlikely to
shift down or to the right. Second, when they do suffer price cuts (as in Japan),
it can lead to disastrous deflation.
See
Also
Aggregate
supply
Aggregation of individual demand to total, or market, demand - a similar
discussion to this article but discussing the attempts to build aggregate demand
up from a microeconomic basis.
List of economics topics
Economics,
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