Understanding Aggregate Demand: The Last Refuge Of An Economist

Demand is the most important word in the economist’s dictionary. During economic booms economists argue that rising demand must be the driver, while recessions must be caused by a lack of demand. The analysis often stops there, with little attempt to look beyond the proximate cause. Demand is used as a stop gap in lieu of a more detailed understanding of the dynamics at play. The word shares a similar status as God did to people thousands of years ago when trying to explain things they did not understand about the behavior of the planet or the solar system.

Mainstream economists tend to view the economy as being driven by spending, with the economy largely beholden to the spending habits of consumers. We often hear how the U.S. economy is driven by the consumer. While individual consumer tastes and preferences determine which goods are produced, this is very different to consumption driving growth. How much consumers are willing and able to spend has virtually no impact on the output of the economy as a whole.

Conflating Individual Goods With The Economy As A Whole

The main reason economists focus on aggregate demand is that they conflate the behavior of individual goods production with the economy as a whole. Individual consumer preferences determine what goods and services businesses make with the finite resources (land, labor, and capital) at their disposal. An increase in demand for and spending on one product encourages producers to increase the output of that particular good at the expense of another.

However, increased real spending on all goods in the economy can only happen if the supply of goods first increases. The willingness of consumers to spend their money has no bearing on the ability of producers to produce. Their ability to purchase goods entirely reflects the ability of producers to produce.

Indeed, the whole basis of the study of economics is about how to satisfy unlimited wants with finite resources. An increase in the so-called demand for a product does not magically allow that product to be produced. Over time, more goods are able to be produced due to improved technology and greater amounts of capital, which allows an economy to satisfy increasing amounts of infinite demand.

The Aggregate Demand Equation Measures Aggregate Production, Not Demand

As all goods that are produced in an economy are bought and sold by someone, economists believe that the more spending that takes place, the more production that will result. We see headlines daily in the financial media about the importance of increasing spending to get the economy going.

Rather than measuring aggregate demand, however, the equation below actually measures the nominal value of goods (and services) that businesses were able to produce in their pursuit of meeting infinite demand. It also measures how much of an economy’s aggregate production is apportioned to each sector of the economy – private consumer goods, public consumer goods, investment goods, and exports.

In the case of the U.S., the majority of final goods and services output is in the form of consumer goods. However, in no way does this mean that consumer demand drives overall production. Private consumption measures how much consumer demand can be satisfied by overall production. If individuals wished to increase the amount of consumer goods they consume in any particular period, this would not result in higher overall production. Higher consumer goods production can only come at the expense of the production of investment goods, goods for public consumption, or goods for export.

Again, real gross domestic product is not constrained by how much stuff people demand or how much money they spend on that stuff in dollar terms, but how much producers are able to produce. The reason for the low level of production in sub-Saharan Africa, for example, is not because it has a low level of demand but because it faces obstacles to increasingly supply, preventing producers from meeting demand.

The Role Of Capital Formation

The failure on behalf of economists to understand that demand is not the driver of production likely stems from the belief that the economy is made up simply of consumers who purchase consumer goods and producers who make them, with no role whatsoever played by capital. In this framework, an increase in consumer spending allows producers to produce more while a decrease in consumer spending causes producers to produce less. Savings, in this model, are effectively a drag on aggregate demand, undermining consumption and therefore production.

In reality, the economy is a complex structure of producers which ultimately transform raw materials and labour into finished consumer products via a chain of capital formation and augmentation. When consumers decide to increase spending or reduce their savings rate, it has little baring on the economy’s overall level of output. Such a decline in the savings rate simply sends a signal to businesses to produce more consumer goods relative to capital goods.

Alternatively, a rise in the consumer savings rate does not result in an overall decline in production. Rather, it allows resources to shift away from producing consumer goods and towards capital formation, enabling them to ‘lengthen the structure of production’ and ultimately produce more consumer goods in the future. It is the very fact that individuals save a portion of their production that has allowed us to move from a hunter-gather society to a highly sophisticated one where almost all of our essential needs can be met.

What About Idle Capacity?

An assertion that is often made is that an increase in aggregate spending, either by creating more money or by encouraging consumers to spend more of their existing money, can support growth if there is idle capacity, which tends to mean high levels of unemployment. For instance, if a coal mine is closed in a particular community it is argued that providing money to those laid off so they can continue spending may prevent further damage to the local economy.

The problem is, as explained above, spending does not create production. Any beneficial impact to the specific community will be offset by the fact that the laid off coal workers now have a claim on the finite amount of consumer goods production, at the expense of everyone else in the broader economy.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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