Aggregate demand is the total demand for goods and services in the economy. The aggregate demand curve shows the relationship between the price level and the corresponding output. The components of aggregate demand are household consumption, private sector investments, government expenditures and net exports, which equal exports minus imports. The factors influencing these components include expectations about the future, exchange rates and fiscal as well as monetary policies.
Income, financial markets and home prices are some determinants of wealth. When people have a steady income, they are likely to spend more. Similarly, profitable businesses are likely to increase their hiring and investment plans. Financial market levels create a wealth effect, because retirement and other investment portfolios contain stocks, bonds and other financial securities. When portfolios rise in value, consumers are likely to feel wealthier and spend more. Home prices also affect household expenditures, because of the same wealth effect. High home equity values mean people are likely to trade up to bigger homes or take out a home equity line of credit for renovations and other expenditures. Accordingly, aggregate demand falls when income levels, financial markets and home prices are in a slump.
Consumer and business expectations about economic conditions influence aggregate demand. If consumers are having difficulty finding a job or they expect employers to reduce staff in the near future, they are likely to save more of their disposable income. This reduces demand for goods and services, which affects business revenues and thus, capital investments and aggregate demand. Conversely, consumers and businesses spend more if they feel confident about the future, which increases aggregate demand. Expectations about future price increases or expiring tax incentives might also lead to a short-term increase in consumer and business spending and thus aggregate demand.
Fiscal and monetary policies influence aggregate demand. For example, tax incentives to depreciate or write off certain equipment purchases faster could lead to increased private-sector investments, which could create jobs and stimulate household expenditures. Similarly, government stimulus spending during a recession creates jobs, which drives consumer and business spending. The U.S. Federal Reserve sets monetary policy by setting short-term interest rates. Rising rates lead to increased interest costs and reduced demand, while falling rates reduce interest costs and increase demand.
Exchange rates influence the net exports component of aggregate demand. For example, when the value of the U.S. dollar falls compared with other major currencies, U.S. goods and services become cheaper overseas. This increases exports, creates more jobs in the manufacturing and other exporting sectors in the United States and could lead to increased aggregate demand. Conversely, a stronger U.S. dollar would make exports more expensive but imports cheaper, potentially reducing aggregate demand.