EFA (46): Aggregate demand

Economics, as my pet parrot and brilliant economic advisor Maynard knows all too well, is all about supply and demand. And “aggregate demand” is the subject of the 46th item in our series, Economics for Amateurs (EFA).

As I have mentioned a few times here before, Maynard is named after Britain’s most famous economist, John Maynard Keynes (1883–1946). And “supply and demand” is his favourite phrase (Maynard’s not Keynes’s).

Many debates in economics  concern the relative importance of supply and demand in determining the level of output in an economy.

“Demand-side economists”, who are often found on the left of the political spectrum, emphasize the importance of demand. These people normally support measures to boost purchasing power (demand), such as wage increases or tax cuts, particulartly for those on lower incomes.

“Supply-side economists”, on the other hand, emphasize incentives to work hard and increase output (supply). So these people favour tax cuts — particularly for those on higher incomes — for a different reason, to increase productivity.

Clearly, however, without demand there would be neither employment nor supply. And without supply, there would be nothing to buy — and no incomes to create demand anyway. That’s what makes life so complicated.

At the micro-economic level, economists look at the demand and supply for individual goods. At the macro-economic level, they look at the total level of demand, which is also called "aggregate demand".

Aggregate demand is traditionally broken down into various parts, depending on the source of the demand. These parts are:

• The demand from the private sector for consumption goods/services
  
• The demand from the private sector for investment goods
• The demand from the government for goods and services of all types
• The demand from people abroad for our exports

When analyzing how countries are growing, we often look at the way these various components are developing. For example, in the fourth quarter of 2009, the US economy as a whole grew at an annual rate of 5.7 per cent, as I discussed here.

But the growth rates of the component parts were highly varied. Consumption grew by just two per cent, while investment rose at an annual rate of more than 13 per cent and government non-military spending rose by just over eight per cent.