Economics - Aggregate Demand

Introduction

Aggregate demand is normally understood in the context of the total value of goods and services demanded by a given group of consumers at a given time period and at a given price (Brux 2007, p. 375). In other words, aggregate demand essentially refers to the value of goods and services consumers are willing to purchase at various price levels. In certain economic literature, the aggregate demand is often referred to as the 'effective demand' but it bears close similarity to the gross domestic product of a given country when the inventory does not change (Murad 1962). An increase or decrease in aggregate demand is brought about by a number of factors but the most common are the increase or decrease in investments and in equal measure, the increase or decrease in consumers' disposable income (Baumol 2009, p. 606). Aggregate demand shares a strong relationship with basic functional areas of the economy because economics is more or less defined by the demand and supply of goods and services (among other factors). However, this study seeks to establish the relationship between aggregate demand and unemployment, inflation, balance of payment (BOP) and the economic growth of an economy. This analysis will therefore constitute the overall overview of how aggregate demand interacts with basic macro economic factors.

Unemployment

Unemployment is normally represented as a state in the economy where the number of people willing and are able to work fail to find employment positions (Kheir-El-D 2008, p. 141). For computation purposes, unemployment is normally expressed as a percentage of the total number of workforce a nation has but its correct ascertainment is usually a variable of a number of factors in the economy such as the aggregate demand. The aggregate demand has a unique relationship with unemployment. The relationship is however not evident to the 'naked' eye because it is rather indirect. Basically, aggregate demand is a function of the supply and demand of goods and services while the supply or demand of goods and services are also independent variables that affect unemployment in the long run and short run (Wessels 2006, p. 123). This relationship can be best explained by the fact that for employment to be evidenced there ought to be a high demand for goods and services (a situation that enables production firms to have a higher capacity of employing more people).

Aggregate demand is in fact in the middle of the entire equation because if the aggregate demand is high, the supply and demand of goods and services in the economy will essentially be high as well. This is caused by the fact that many consumers will have a higher disposable income when aggregate demand is high and this situation also has the potential of increasing the total gross national output as well. The above relationship between aggregate demand and consumer disposal is brought about by the fact that there is a positive relationship between disposable income and aggregate demand which is best encompassed in the consumption function described by the Keynesian cross (Heijdra 2009, p. 25). This means that the economy will be robust and goods and services will be produced in mass. It is only when such conditions are evident that employment actually takes place. Many people will therefore be employed to sustain the high demand for goods and services while many more people will be employed to support the increasingly long supply chain.

This concept is best explained through the Keynesian theory which Kling (2011) summarizes that "When aggregate demand goes up in the economy, employment goes up and unemployment goes down. This makes sense, because as firms strive to meet the need for more output, they have to hire more workers" (p. 12). It is also important to note that unemployment does not occur when the aggregate demand is high because during times of a high aggregate demand, there are more opportunities for job creation and this eventually leads to a decrease in unemployment. In this type of situation, it is even easy to sustain low levels of unemployment even when people leave their jobs because of termination, lay-offs, resignations and the likes because they can easily switch one job to another without experiencing long periods of unemployment. This was the situation experienced in the United States (US) during the 1990s period where the country's major media corporations were extensively laying off their workers but interestingly, at the same time, the country was experiencing declining unemployment rates (Kling 2011). Needless to say, the aggregate demand for goods and services at this time was high. However, it is important to note that when aggregate demand is high and unemployment rates are low, there is a high likelihood that inflation will set in because many people will have a high disposable income, thereby leading to the increase of the prices of goods and services.

Inflation

Inflation is normally referred to as the persistent increase in the price of goods and services in an economy (Jain 2011, p. 245). It is normally caused by a number of factors but the most common factor is the increase in the supply of money in the economy. This variable (inflation) is normally ascertained through the consumer price index and the producer price index; both of which are normally relied on by many international economists. Inflation therefore implies that the amount of goods or services