The notion of aggregate demand formally made its appearance in John Maynard Keynes’s (1883-1946) General Theory in 1936 and, in its numerous guises, quickly rose to become a vital concept in economists’ tool kit of analytical devices. Despite pleas by some economists, notably new classical economists, to reject the aggregate demand/supply framework because of lack of rigorous microeconomic foundations (see, among others, Barro 1994), the aggregate demand function has retained a central but highly debated role in macroeconomic analysis.
Though he regarded it as his major analytical innovation (King 1994, p. 5), Keynes defined his aggregate demand function in a way that would be unfamiliar to most economists nowadays. This is because the aggregate demand function was conceived as a subjective aggregate relation linking entrepreneurs’ offers of employment to the anticipated overall market demand (or expected proceeds) for their firms’ output. Keynes wrote: "Let D be the proceeds which entrepreneurs expect to receive from the employment of N men, the relationship between D and N being written D = f(N), which can be called the aggregate demand function (Keynes 1936, p. 25). Given entrepreneurial perceptions of firms’ investment plans, and expected flow of household consumption arising from hypothetical employment offers, an aggregate functional relation could be delineated in a two-dimensional D-N space: "The aggregate demand function relates various hypothetical quantities of employment to the proceeds their outputs are expected to yield" (Keynes 1936, p. 55).
There is a positive relationship between aggregate income and employment because increased employment offers will bring forth higher expected proceeds from household consumption. Indeed, the greater the share of spending out of each additional dollar of income—that is, the higher the marginal propensity to consume—the higher the level of additional income associated with increased employment (Asimakopulos 1991, p. 45).
When depicted in D-N space with an aggregate supply function (the latter resting on a standard Marshallian microfoundation and representing the desired proceeds that would just make it worth the while of entrepreneurs to employ N workers), short-period equilibrium is achieved at the intersection of the aggregate demand and supply curves, dubbed the point of effective demand. On this basis, Keynes rejected classical-type theories founded on the Say’s Law principle (that "supply creates its own demand") by arguing that the latter doctrine did not assume an independent aggregate demand function that could conceivably result in an equilibrium point at less than full employment.
While the development of his aggregate demand concept was of major theoretical and policy significance, particularly in its support of activist taxation, spending, and monetary policies of aggregate demand management, there were obvious problems with Keynes’s original formulation. For instance, unless the business sector is conceived as one large firm that can envision the impact of its employment decision on its own expected proceeds, how exactly could a multitude of uncoordinated decisions by competitive firms be collectively anticipated by entrepreneurs and represented in an aggregate demand relation? As a result of such theoretical conundrums, the concept was to undergo tremendous transformations during the post-World War II (1939-1945) period as economists sought conceptually less challengeable theoretical constructs.
Even among fundamentalist Keynesians of the early postwar years, such as Sidney Weintraub (1914-1983) and Paul Davidson, the aggregate demand function, D, came to be treated no longer as an expected proceeds curve as perceived by entrepreneurs, but simply as a representation of the intended spending on the part of economic agents (consumers, firms, and governments) associated with hypothetical levels of total employment. Indeed, in the hands of numerous early postwar Keynesians such as Paul Samuelson, Keynes’s original association between sales proceeds and employment was to be transformed into a relation between aggregate intended expenditures of economic agents and the level of real income or output, as depicted in the framework of the popular 45-degree diagrams found in many introductory textbooks (Dutt 2002, p. 329).
Because of its implicit assumption of fixed price, the 45-degree aggregate expenditure relation slowly succumbed to alternative formulations of the aggregate demand function as economists struggled to incorporate the effect of changes in prices within a competing analytical framework. This resulted in redefining a downward-sloping aggregate demand function within aggregate price-output space seemingly comparable to its traditional Marshallian microeconomic counterpart. However, to ensure a negative slope, this latter incarnation of the aggregate demand function had to rely on somewhat more questionable assumptions than its previous upward-sloping Keynesian aggregate expenditure relation in the context of 45-degree diagrams. This is because, as prices rise, it is assumed that the purchasing power of household wealth and cash balances declines and thereby household spending (aggregate demand) also declines. These so-called wealth effects and real balance effects assume that currency held by households plus reserves held by banks exceed the value of bank deposits. In fact, however, bank deposits greatly exceed the value of bank reserves plus currency held by households. Hence, the relevance of real balance effects has been seriously questioned. This is why modern macroeconomic textbooks have slowly been abandoning this form of aggregate demand analysis (in price-output space) and relying simply on a dynamic relation that links inflation to an economy-wide capacity utilization rate—a variant of the Phillips Curve. Unfortunately, the latter is a far cry from Keynes’s unique formulation of the aggregate demand function that related aggregate expected proceeds to the level of employment.
