Aggregate demand (AD) management policies are used by the federal government to control the amount of total macroeconomic demand in the economy. The two major AD policies used by the government to control AD are fiscal policy and monetary policy. English economist John Maynard Keynes first developed the models for the management of AD.
Supply and Demand
The U.S. economy consists of two primary elements: aggregate supply (AS) and aggregate demand (AD). In simplistic terms, AS represents the capacity of the economy to produce goods and services stated as the total dollar value of the output, while AD represents the dollar value of the demand for the goods and services by all consumers and the government itself.
The management policies used to control AD can increase AD by putting more purchasing power into the economy through reduced taxes or lower interest rates; or it can reduce AD by lowering the purchasing power of the economy via raising taxes or increasing interest rates. Fiscal policy is used to raise and lower taxes,while monetary policy is used to affect interest rates by increasing or decreasing the amount of money available in the economy.
The use of fiscal and monetary policy is intended to manage and stabilize the economy by controlling AD to prevent a surplus of demand or a shortage of supply. When the AD equals the AS, the economy is said to be in equilibrium -- or as some call it "full employment."
When the government wishes to increase AD, Congress is called upon to lower taxes (fiscal policy) or the Federal Reserve Bank is urged to increase the money supply (monetary policy). Both of these actions provides more money to the economy with the hope that consumers will increase their demand for goods and services. However, should the government wish to decrease AD, taxes can be increased or the money supply restricted to decrease the amount of money available to consumers for purchasing goods and services.
AD and AS
Whether monetary policy or fiscal policy is applied to manage the economy, the change in the AD affects the AS. While it's not really as simple as this, when consumers or the government are buying less, producers are likely to produce less; this results in a reduction in AS, nudging the economy towards equilibrium. Conversely, if consumers have more money to spend on goods and services AD is likely to increase, along with AS in time.
Surplus and Shortage
Fiscal and monetary policies can also be applied to move AD toward AS by attempting to eliminate a surplus or shortage of goods and services. Increasing demand should stimulate production, while decreasing demand should cause producers to cut back. The government, primarily Congress and the Federal Reserve, apply the policies over which they have control in the attempt to regulate the economy. Although it rarely happens, when the economy is in equilibrium employment is high, prices are stable and the AS equals the AD.