Demand is the underlying force that drives everything in the economy. Fortunately for economics, people are never satisfied. They always want more. This drives economic growth and expansion. Without demand, no business would ever bother producing anything.
Businesses Depend on DemandAll businesses try to understand or guide consumer demand, so they can be the first or the cheapest in delivering the right products and services. If something is in high demand, businesses make more revenue. If they can't make more fast enough, the price goes up. If the price increase is sustained over time, then you have inflation.
Conversely, if demand drops then businesses will first lower the price, hoping to shift demand from their competitors and take more market share. If demand isn't restored, they will innovate and create a better product. If demand still doesn't rebound, then companies will produce less and lay off workers. This contraction phase of the business cycle can end in a recession.
Demand and Fiscal PolicyThe Federal government also tries to manage demand to prevent either inflation or recession. This ideal situation is known as the Goldilocks economy. Policymakers use fiscal policy to boost demand in a recession or subdue demand in inflation. To boost demand, it either cuts taxes, purchases goods and services from businesses, or gives subsidies and benefits such as unemployment benefits. To subdue demand, it can raise taxes, cut spending and withdraw subsidies and benefits. However, this usually angers beneficiaries, and leads to the elected officials being booted out of office.
Demand and Monetary PolicyTherefore, most inflation fighting is left to the Federal Reserve and monetary policy. The Fed's most effective tool for reducing demand is increasing prices, which it does by raising interest rates. This reduces the money supply, which reduces lending. With less to spend, consumers and businesses might want more, but they have less money to do it with.
The Fed also has powerful tools to boost demand. It can make prices cheaper by lowering interest rates and increasing the money supply. With more money to spend, businesses and consumers can buy more.
However, even the Fed is limited in boosting demand. If unemployment remains high for a long period of time, then consumers don't have the money to get basic needs met. No amount of low interest rates can help them, because they can't take advantage of low-cost loans. They need jobs to provide income and confidence in the future. Therefore, demand is based on confidence and enough decent, well-paying jobs. Find out the Best Ways to Create Jobs.
Determinants of DemandThere are five determinants of demand. The first two are prices: that of the good or service itself, and the price of either substitutes or complementary goods or services. The next three are driven by consumer circumstances: their incomes, their tastes and their expectations. For more on how these five factors affect demand, see Determinants of Demand.
Law of DemandThe relationship between the quantity demanded and the price is governed by the law of demand. This economic principle describes something you already intuitively know -- if the price goes up, people buy less. The reverse is, of course, true -- if the price drops, people buy more. However, price is not the only determining factor. Therefore, the law of demand is only true if all other determinants don't change. In economics, this is known as ceteris paribus. Therefore, the law of demand formally states that, ceteribus paribus, the quantity demanded for a good or service is inversely related to the price.
Demand ScheduleThe demand schedule is a table or formula that tells you how many units of a good or service will be demanded at the various prices, ceteris paribus.
If you were to plot out how many units you would buy at different prices, then you've created a demand curve. It graphically portrays the data in a demand schedule. When the demand curve is relatively flat, then people will buy a lot more even if the price changes just a little. When the demand curve is fairly steep, than the quantity demanded doesn't change much, even though the price does.
Elasticity of DemandDemand elasticity means how much more, or less, demand changes when the price does. It's specifically measured as a ratio -- the percent change of the quantity demanded divided by the percent change in price. There are three levels of demand elasticity:
- Unit elastic is when demand changes the exact same percent as the price does.
- Elastic is when demand changes by a greater percent than the price does.
- Inelastic is when demand changes a smaller percent than the price does.
Aggregate DemandAggregate demand, or market demand, is another way of saying demand of any group of people. It is governed by the five determinants of individual demand, plus a sixth: the number of buyers in the market.
The aggregate demand for a country measures the quantity of the goods or services it produces that is demanded by the world's population. For that reason, it is composed of the same four things that make up Gross Domestic Product: