A country’s aggregate demand is the total demand for all final goods and services produced within a country that consumers, businesses, government, and foreigners want to buy at a given price level.
An economy’s participants include consumers, producers, government, and foreigners. Aggregate means “total,” so an economy’s aggregate demand 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 expenditures, investment, government demand, and net exports. An economy’s aggregate demand increases when the sum of these variables increases.
Understanding the difference between the demand curve for an individual good or service (microeconomics) and the aggregate demand for an economy (macroeconomics) is important. Graph 1 shows the demand curve 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 that consumers may substitute another fruit for apples. Economists assume that the price of an apple changes, but the prices of all other goods remain constant when graphing the demand curve for a specific good or service, such as apples.
Graph 2 provides the aggregate demand curve for an economy. The aggregate demand curve is for all final goods and services. Most of the goods and services are unrelated and have different prices. When graphing an aggregate demand curve, 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 that people may feel wealthier and can 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 aims to increase 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 can increase an economy’s aggregate demand by providing incentives that promote consumer or business spending. For example, 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 usually exercised when there is a recessionary gap.
When the economy is overheated, policymakers may use contractionary fiscal policy to reduce inflation by reducing or slowing the growth of the economy’s aggregate demand. Increasing taxes and reducing government spending qualify as contractionary policies.
Here's a short video that explains Aggregate Demand in more detail: