Aggregate Demand

What is aggregate demand? Aggregate demand refers to total expenditure in an economy in a certain period. That is, aggregate demand comprises everything that is spend in an economy in one period. One can split aggregate demand into different subcomponents. Formally, one can describe aggregate demand (Y) as

Y = C + I + G + NX

As one can see from the equation above, aggregate demand (Y) is equal consumption (C) plus investment (I) plus government spending (G) plus net exports (NX), i.e. how much we are selling abroad to other countries on net.

According to Keynesian theory, aggregate demand determines the amount of available expenditure in an economy. Now, why should one care about available expenditure? Well, in Keynesian economics, available expenditure determines the amount of means available in an economy in order to sustain labor hires in a given period. That is, in the Keynesian model, the available expenditures is what keeps people at work. Boldly speaking, the amount of expenditure defines the amount of available money to pay the wages of workers. This concept is particularly important during a recession. Assume for instance, that a shock hits the economy and aggregate demand decreases. This implies that demand for firms’ products drops and firms will sell less products and earn less money. Hence, at the end of the month firms have less money available to pay their employees. Meaning that firms will be forced to lay off some workers and unemployment increases. Hence, in a Keynesian setting, a drop in aggregate demand implies a decrease in the means available in an economy, leading to less jobs and higher unemployment.

In order for the Keynesian aggregate demand-employment relationship to work, Keynesians rely on an important assumption: price stickiness. That is, Keynesian Economics typically assumes that nominal wages are sticky. Now, what does sticky wages mean? In order to answer this question think of wage as the price of labor. In addition, assume for a second that wage behaves just like any other price. In a typical market, if demand for a certain product falls then the price of this product will fall as well. If this mechanism were true also for the labor market, a drop in aggregate demand would mean that the price of labor (wage) decreases and not mean that people are losing their jobs. However, wages are unlike many other prices. They do not always adjust so quickly. Hence, we say that wages are sticky or rigid. Why is that? Why do wages not adjust so quickly? There are several reasons for that. First, there might be a long-term contract between the employer and the employee. Second, there may be a law, such as the minimum wage law, that prevents wages from falling below a certain threshold. Finally, worker moral might also contribute to wage stickiness. Especially when aggregate demand is raising, workers could demand higher wages, but often do not ask for a raise for moral reasons.

It is important to understand that wage stickiness has severe consequences for employment. Once the flow of aggregate demand expenditure slows down and firms cannot cut wages, firms need either fire workers or exit the market, i.e. declare bankruptcy. Moreover, the reduction of workers triggers a second round feedback loop. Meaning that once there are less people working, the flow of aggregate demand expenditure will decrease even more. The reason being that there is lower employment and hence lower production and thus less earning to be consumed, resulting in less investment and less aggregate demand. Therefore, at the end of the month, firms have even less money to pay wages and will be forced to lay off even more workers.

Keep in mind that in typical Keynesian scenario if consumption and investment are falling usually government spending is going to end up falling as well. The reason being that a lower aggregate demand means that firms produce and sell less. Hence, less tax revenue is generated. Consequently, unless the government is borrowing money, a reduction in aggregate demand reduces also the government’s ability to spend money. Thus, as government spending is part of aggregate demand, there will be an additional negative shock to aggregate demand.

Did we already experience sharp drops of aggregate demand in the past? John Maynard Keynes wrote its book in the 1930s, right in the aftermath of the Great Depression. Up to date, the Great Depression represents the most prominent reduction of aggregate demand experienced in modern history. Starting in 1929, many banks failed and many depositors lost their money. Note that this was still a time before governmental guarantees. The money supply fell by about a third and the stock market crashed. This caused consumer spending to decrease, a drop in investment, and a reduction in aggregate demand. Thus, the sharp reduction in aggregate demand led to the Great Depression with high levels of unemployment. More recently, we experienced yet another prominent drop in aggregate demand. Although the Great Recession of 2008 was much less severe than the Great Depression, it also had an considerable Keynesian element.

 

Overview: Keynesian Economics

1) Keynesian Economics
2) Aggregate Demand
3) Keynesian Economics in an AS-AD model
4) How to get out of a recession?
5) Drawbacks of Keynesian Economics

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