Aggregate demand is the total goods and services that consumers, businesses, government, and foreigners want to buy at a given price level in an economy.
The primary participants in any economy include consumers, producers, government, and foreigners. Aggregate means “total”, so the aggregate demand of an economy is the total quantity demanded by these participants. It is measured as the gross domestic product (GDP) when using nominal prices, and as the real gross domestic product (RGDP) when the GDP is adjusted for inflation. Aggregate demand includes personal consumption, investment, government demand, and net exports. An economy’s aggregate demand increases when the sum of these variables increases.
It is important to understand the difference between the demand curve for an individual good or service (microeconomics) and the aggregate demand for an economy (macroeconomics). Graph 1 is the demand for apples. The vertical axis is the price of apples, and the horizontal axis is the number of apples purchased at any price. The demand for apples has a negative slope because as the price of apples increases, people buy fewer apples. One reason is consumers may substitute another fruit for apples. Economists assume that the price of apples changes, but the prices of all other goods remain constant when graphing the demand curve for an individual good or service.
Graph 2 is the aggregate demand for an economy. The aggregate demand curve is for all final goods and services, most of which are unrelated and have different prices. When graphing the aggregate demand, the vertical axis is the price level of an economy, not the price of one good or service as with the demand curve for apples. The horizontal axis is RGDP, or the total production for the economy after being adjusted for inflation. The real gross domestic product increases as an economy's price level falls. One reason is because people may feel wealthier and are able to purchase more for their money when the price level falls. When graphing the aggregate demand curve, economists assume that the prices of all goods and services increase or decrease at the same rate.
Expansionary fiscal policy has the objective of increasing either an economy's aggregate demand or aggregate supply to stimulate growth and employment. Methods include decreasing taxes, increasing spending, or a combination of both. Laws that provide incentives to change behavior that promote spending may also qualify as fiscal policy. Permitting mortgage interest to be deducted from taxable income is an example because the deduction reduces taxes and induces families to purchase homes. Expansionary fiscal policy is normally exercised during periods of a recessionary gap.
When the economy is overheated, contractionary fiscal policy may be used. Contractionary fiscal policy is any fiscal policy which has the objective of slowing down the economy. The goal is to reduce inflationary pressure. Increasing taxes and reducing government spending qualify as contractionary policies.
Here's a short video that explains Aggregate Demand in more detail: