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Why Doesn't an Increase in Aggregate Demand Translate Directly Into an Increase in Real GDP?

Original post by Michael Wolfe of Demand Media

It is a truism of economists that most economic principles can be traced back to supply and demand. Supply and demand can take many forms, such as the demand for goods, demand for services and demand for labor. In some cases, this demand will correlate with the gross domestic product of the country. However, a rise in aggregate demand does not directly lead to a rise in real GDP because GDP is influenced by many factors.

Aggregate Demand

The term "aggregate demand" refers to the total demand for all of a country's goods and services. Demand can be quantified in many different ways, but it is often represented graphically, in the form of a curve, usually with one axis represented by price levels and the other by real GDP. This curve slopes downward in most cases. An increase in real GDP accompanies a lowering of prices.

Real GDP

Real GDP is the total production of goods and services within a particular economy. The term "real" means that the GDP is being adjusted for inflation. This means that while a normal GDP may show a year-over-year increase, as expressed in dollars, this may be illusory if the dollar has merely inflated in value. A real GDP is adjusted for inflation, for a more accurate measurement of economic production.

Relationship

An increase in aggregate demand may produce an increase in the real GDP. This is because the increase in demand will generally compel the GDP to increase. However, while this relationship is clear enough in theory, this only holds true is there is enough supply to meet this demand. If supply lags behind demand, then the GDP may not have increased and demand may be going unmet.

Reasons for Non-Correlation

There are many reasons that GDP may not increase with aggregate demand. For example, if the economy's producers are unable to meet demand due to an unexpected shortage of raw materials or labor, government restrictions or because they cannot charge a price that would allow them to make a profit. However, if producers can meet aggregate demand, it will cause an increase in real GDP.

                   

References

  • "Economics"; Roger A. Arnold; 2008

About the Author

Michael Wolfe has been writing and editing since 2005, with a background including both business and creative writing. He has worked as a reporter for a community newspaper in New York City and a federal policy newsletter in Washington, D.C. Wolfe holds a B.A. in art history and is a resident of Brooklyn, N.Y.

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