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Aggregate demand can help investors get an idea of the health of a nation's economy.

If you're trying to gauge the economic strength of a country, and the future prospects of a market as an investor, you need to look at aggregate demand.

What Is Aggregate Demand?

Aggregate demand is a means of looking at the entire demand for goods and services in any economy. It is a tool of macro economists, used to help determine or predict overall economic strength within a country, in a given period of time -- usually a year.

Aggregate demand is used by macro economists as a means of gauging a country's economic position in that time period. Following changes in aggregate demand is crucial to understanding fluctuations in economic cycles. It helps one see how a country moves from a slowdown to an actual recession, or how a country can emerge from a recession into a recovery.

Looking at aggregate demand can also give a view into a country's trade position. If the value of imports is higher than that of exports, for example, the country has a trade deficit with the countries from which it imports goods - like the U.S. has had for decades with China.

The role of aggregate demand in employment was discussed by economist John Maynard Keynes in his last book, "The General Theory of Employment, Interest and Money," that was published in 1936, in the midst of The Great Depression. Keynes theorized an economy would not automatically provide full employment, even in equilibrium. Instead he suggested the volatile and ungovernable psychology of markets would lead to boom and bust cycles. The heart of Keynes' theory was that the level of employment isn't determined by the price of labor, as classical economics proposed, but by the level of aggregate demand.

An example of this can be seen in the market's reaction, for instance, to the imposition of tariffs on imported goods by the U.S. in 2018, particularly from China, and the effect of any inkling of negotiations between the U.S. and China resulting in a successful outcome.

Within his treatise was a revolutionary way of thinking about prices, wages and employment, and the suggestion that governments could affect aggregate demand and, therefore, employment, by pouring money into an economy even at a deficit to employ idle workers who then will spend money they otherwise didn't have.

In short, he came up with a theory that supported government spending to solve economic crises like The Great Depression.

Aggregate demand is important as a means of gauging the effect of prices on productivity, too. Classical economic theory had suggested that only prices could affect employment, and that a change in prices or productivity would not really affect demand.

What Is the Aggregate Demand Curve?

Keynes came up with a means of gauging the effects of changes in components of aggregate demand in relation to aggregate supply by graphing instances using the aggregate demand curve.

An aggregate demand curve shows the relationship between output and all prices. Ultimately, the aggregate demand curve is downward-sloping, because it indicates Real Gross Domestic Product (GDP) will decline as prices rise.

These concepts are important for understanding how policy decisions by governments and central banks affect the health -- aggregate demand -- of a country's economy. Prior to Keynes, the effects of ungovernable events or shocks weren't considered, nor were government policies on trade, exchange rates and money supply.

The Components of Aggregate Demand

The components of aggregate demand (AD) are:

  • C = Consumption, or Household Spending on Goods and Services. In most countries -- particularly developed ones -- this is the largest component in aggregate demand.
  • I = Gross Fixed Capital Investment (Spending by businesses and governments on capital goods, like plant and equipment, technology, new buildings, which allow production of more consumer goods in the future). "I" also is the value of the change in stocks/inventories, components and finished products, or working capital investment.
  • G = Government spending on public services, spending on state-provided goods and services.
  • X = Exports of goods and services -- sold overseas, an inflow of aggregate demand, and an injection of spending into our circular flow of income and spending.
  • M = Minus imports of goods and services, or a withdrawal of demand, also considered a "leakage" of a country's circular flow of income and spending.

How to Calculate Aggregate Demand

So, to determine the aggregate demand in a country's economy, you need to use the formula:

C+I+G+ (X-M) = AD, or Gross Domestic Product based on expenditure: the "actual" value of goods and services produced within a country.

What Factors Impact Aggregate Demand?

Things that affect aggregate demand, and that can cause it to contract, are:

  • A fall in net exports: a fall in net exports could cause aggregate demand to contract, as it would move inward along the Real GDP Axis. Similarly, an increase in net exports could have the opposite effect -- causing aggregate demand to move outward along the Real GDP axis.
  • A cut in government spending: This is among the most contentious aspects of Keynes' theory of aggregate demand and employment. Keynes, observing The Great Depression, saw that prices didn't really move much despite massive unemployment. His solution was for government spending to actually increase, by putting money (spending power) in the hands of workers who wanted to work but for whom there were no jobs. These individuals, he reasoned, would spend money if they had it -- increasing consumption, and thereby increasing Aggregate Demand. For this reason, a cut in government spending, as witnessed in recent "austerity" budgets, has the opposite effect and usually does neither increase employment nor consumption. 
  • Higher interest rates: during The Great Recession of 2008-09 in the U.S., and for nearly a decade after, the Federal Reserve, the "central bank" of the U.S., kept its Federal Funds Target Rate at 0%-0.25%. This had the result of banks being able to borrow from "the lender of last resort" at nearly free interest, supplying liquidity to financial institutions to be able to extend credit.
  • A decline in household wealth and consumer confidence: While a decline in household wealth can be quantified, statistically, consumer confidence is far more subjective. But confidence, often supported by an increase in household (consumer) wealth, actually affects expectations of either continued growth or economic contraction. This is why housing prices are as important as wages to consumers. When wages don't keep pace with prices, consumers start to put off or avoid spending for fear it might put them into financial trouble. Similarly, when housing prices fall, it reduces household wealth, which causes homeowners and consumers to tighten their spending.

In short, anything that causes people -- and countries -- to cut back on spending can cause a contraction in aggregate demand. Because, as noted, consumption (spending) is the largest component in most countries' aggregate demand.

Similarly, anything that sparks consumption -- spending -- by people can cause a rise in aggregate demand, such as a depreciation of the currency in exchange rates with other currencies, making exports more competitive in markets overseas; cuts in direct or indirect taxes -- more money in peoples' pockets tends to spur spending; an increase in housing prices, which results in an increase in consumer wealth and confidence; or an expansion of supply of credit with lower interest rates, which helps people purchase more expensive things like houses.

However, most countries are susceptible to external shocks which also influence Aggregate Demand. A "shock" is an event that triggers a second or third round response in demand, production and jobs.

Shocks include: sudden movements in the exchange rate, affecting the competitiveness in the prices of exports and imports; a recession or slowdown, or even boom in one or more of the nation's major trading partners, for example, in China; a slump in the housing or construction sector of a trading partner, or a systemic problem, such as the 2008-09 global financial crisis, which caused a fall in the supply of credit available to households and businesses; or a large change in commodity prices for a country, like the U.S., that is a commodity exporter.

Countries that have suffered commodity price shocks relatively recently include Russia and Venezuela, as well as all countries in which the economy is largely dependent on the export of one commodity -- such as oil.

Issues With Aggregate Demand

Now, some economists since Keynes have argued, as did, essentially, Keynes himself, that the aggregate demand curve indicates a need for possible government influence on aggregate demand in the "short run," but not the "long run."

When the economy of a country falls into a recession, or as U.S. economists consider it technically two consecutive annualized quarters of contraction (non-growth) in Gross Domestic Product, caused by any sort of shock to aggregate demand, some will demand government intervention, while others will complain that intervention by a government isn't necessary most of the time.

A demand shock -- like a recession, caused by anything affecting aggregate demand, including confidence -- has a short-run effect on output and employment. In the long-run, only price levels will be affected.

This is because, technically speaking, economies do tend to reach an equilibrium between output, demand, prices and employment, over time. The long-run self-adjustment mechanism of an economy can result in equilibrium after a shock. The heart of the self-correction, or self-adjustment, mechanism is prices. When a shock occurs, prices will adjust over time to bring the economy back to equilibrium, which is to say, a point where the amount of output is equal to aggregate demand, and full employment -- the level of employment at the point where output is equal to aggregate demand -- is achieved.

Since aggregate demand is best used with a set period of time, usually a year, you can use it as an investor to help you decide whether or not to invest in an economy, whether it be your own or another country. However, since it is really only a tool for short-run outlooks, if you are considering investing in something longer term, such as government or corporate bonds, it may not be as useful to you and may, in fact, cause you concern where you should be relying more on the long run.