Aggregate Demand: What are the essential components of aggregated demand?

VARUN


The national income and employment in the short run in an economy depend upon aggregate Demand
and aggregate supply. The concept of aggregate demand and aggregate supply was coined by
J.M.Keynes a notable English Economist. He showed the mutual relationship between aggregate
demand and aggregate supply determines the level of income and employment in a free market
Economy, to him the deficiency of aggregate demand relative to aggregate supply of output at full
employment of resources given rise to Unemployment.

Aggregate demand is the total expenditure which the consumers, producers and government are willing
to make on goods and services in a year. The aggregate demand (AD) Comprises of four components (i)
consumption demand (ii) Investment demand (iii) Government expenditure on final good, and services
and (iv) Net of exports over imports consumption expenditure is denoted by C, investment expenditure
by I and Govt expenditure by G and exports by Xn. The net exports is calculated by the difference
between X-M=Xn

Thus Aggregate demand (AD) = C+I+G+Xn

Consumption demand:

The demand for consumer goods and services depends on the propensity to consume and the level of
income of the community. Propensity to consume refers to the general income consumption
relationship. It represents functional relationship between two aggregates, i.e. total consumption and
total income it indicates the proportion of the aggregate income that shall spent on consumption at
various levels of income.

Given the propensity to consume, the amount of consumption demand creases with the increase in
income. Thus consumption demand is function of income.

In the figure given below National income is measure along the X axis and consumption demand (C)
along the Y axis.

(i) The 45% or (Y=C) line indicates that at all the points on this line whole of the income is consumed and
nothing is saved.

(ii) The ABC line (CC) represents consumption function. It is drawn according to the psychological law of
consumption. It indicates that income increases consumption also increases, but not as fast as income.

(iii) The ABC line starts from point A and not from origin 0. This is because when income falls to zero,
consumption does not fall zero.

(iv) When income is less than consumption (at income levels lengthen OY) the gap is covered by dis-
saving

(v) A OY level of in come consumption become equal to Income and there is neither saving no dis-saving.

(vi) When income is more than consumption (at income levels greater than OY) the gap between the 45
line and the ABC line after point B represents positive saving.

However in the short run, propensity to consume, does not change, i.e. consumption function
(propensity to consume) remains constant. The propensity to consume, in the short period, depends on
consumer's tastes and preferences, the rate of interest, the level of prices, the income distribution and
the population. These factors ore or less remain constant during short period. With the increase the
above factors, the whole consumption function curve will shift upward.

Investment demand:

Investment demand is another component of Aggregate demand. Investment means buying of new
physical capital assets such as machinery, tools, equipment, buildings. Expenditure on the stock of
consumer goods and ratio materials is also considered as investment. The investment demand depends
on two factors.

(i) Marginal efficiency of capital

(ii) The rate of interest.

The marginal efficiency of capital (MEC) refers to the expected profitability of a capital asset. It may be
defined as the highest rate of return over cost expected from the marginal or additional unit of a capital
asset. Between the two factors rate of interest is comparatively sticky and does not frequently charge in
the short run. Given the rate of interest changes in investment demand in the short run occur due to the
changes in marginal efficiency of capital. Thus investment demand depends on the profitability from the
employment of additional capital unit.

Government purchases:

The Government expenditure on final goods and services constitutes another component of aggregate
demand. The Govt purchases goods and services for two purposes. Firstly the Govt spends on the
infrastructure like construction of highways, flood control project, education, communication etc. This is
the developmental expenditure of the Govt, secondly the Govt, spend on police and public
administration, defence and other social services.

The first type of Govt, expenditure resembles private investment expenditure and the second type
resembles private consumption expenditure. There expenditures are not productive as it does not help
in producing further goods. Govt, also make expenditure on social security measures like old age
pension sickness benefits, subsidies etc. This type of expenditure is call cash transfer or transfer
payment.

It is important to note the Govt; expenditure is independent of national income an autonomous in
nature like private investment expenditure.

Net Exports:

Export means shipping goods to foreign countries for it represents foreign demand for country's
product. The export revenue i.e. the amount of expenditure on the goods of the exporting country by
the foreign people adds to the total expenditure of aggregate demand in the exporting country's
economy.

Thus exports are like investment expenditure as both create income and demand for good. As against
the export imports of a country generate demand for foreign goods. Therefore imports constitute
leakage from the domestic flow of income and reduce domestic aggregate demand. Thus net exports
over imports (X - M) of a country are a component of aggregate demand.
Components of Aggregate Demand
Introduction

Aggregate demand tells the quantity of goods and services demanded in an economy at a given price
level. In effect, the aggregate demand curve is a just like any other demand curve, but for the sum total
of all goods and services in an economy. It tells the total amount that all consumers, businesses, and the
government are willing to spend on goods and services at different price levels.


The aggregate demand curve can be thought of just like a demand curve for a firm. When the price level
is high, aggregate demand is low; when the price level is low, aggregate demand is high. The aggregate
demand curve lies in a plane consisting of the price level and income or output. It shows a downward
slope with price level on the vertical axis and income or output on the horizontal axis. As such, the
aggregate demand curve outlines the relationship between income or output and the price level. It is
important to notice that aggregate demand is a schedule because as the price level changes, the income
or output also changes.

There are four major components of aggregate demand. The equation for aggregate demand, Y = C(Y -
T) + I(r) + G + NX(e), tells much about the nature of both aggregate demand and the curve that
represents this schedule.

Components of aggregate demand

The equation for aggregate demand proposed by the Mundell-Fleming model of a large open economy
is Y = C(Y - T) + I(r) + G + NX(e). Y represents income or output. C(Y - T) represents consumption as a
function of disposable income, defined as income less taxes. I(r) represents investment as a function of
the interest rate, where an increase in the interest rate decreases investment. G represents government
spending, which is predominately unaffected by interest rates. Finally, NX(e) represents net exports,
defined as exports less imports as a function of the real exchange rate, where an increase in the real
exchange rate decreases net exports. Understanding the details of each component of aggregate
demand is an important first step toward understanding aggregate demand.

The first piece of the aggregate demand equation is Y. This represents output or income. Because Y is
the total amount of goods and services purchased by consumers, businesses, and the government,
taking into account foreign trade, it is necessarily the output for the economy. This number is also the
gross domestic product of an economy. Because every unit of output within an economy turns into
income for members of the economy, it is reasonable to call output income. More specifically, the
output of an economy is the national income for the economy. The per capita income is the national
income for the economy divided by the population. This number is useful for comparing the standard of
living across countries. All of this information directly results from the aggregate demand equation.

The second piece of the aggregate demand equation is C(Y - T). This signifies that consumption is a
function of disposable income. Disposable income is the money that consumers have left to spend after
taxes. The function for consumption is aggregated across all consumers and thus is applicable for all
incomes and tax brackets. Consumption captures spending by households on goods and services.
Examples include purchasing food, movie tickets, and vacations.


The third piece of the aggregate demand equation is I(r). This signifies that investment spending is a
function of the real interest rate. That is, as the real interest rate increases, investment spending falls
because the cost of borrowing money increases. The real interest rate is simply the nominal interest rate
as published in the media corrected for expected inflation. When firms consider investment spending,
they routinely take into account the nominal interest rate, inflation, and the real interest rate. Examples
of investment spending include machinery, buildings, education, and new housing.

The fourth piece of the aggregate demand equation is G. Government spending encompasses every
expenditure made by the government. The total amount of money spent by the government is often
surprising. In fact, it is not unusual for government spending to constitute upwards of one third of gross
domestic product. The level of government spending is a hotly debated topic as political parties vie for
their programs in the annual budget. Examples of government spending include salaries to government
employees, defense spending, welfare and social security programs, and foreign aid.

The fifth piece of the aggregate demand equation is NX(e). Net exports are defined as the difference
between exports and imports. It is important to recognize that net exports are dependent upon the real
exchange rate. As the real exchange rate rises, domestic currency is relatively more valuable and thus
the price of domestic goods is relatively more expensive than the price of foreign goods. In this case,
exports fall and imports rise, causing net exports to decline. Interestingly, a thriving domestic economy
will result in a higher real exchange rate and thus lower net exports. Examples of exports include cars
and electronics made in the US and sold Asian countries. Examples of imports include fruits and
vegetables grown in New Zealand and sold in the US.

The equation for aggregate demand of Y = C(Y - T) + I(r) + G + NX(e) has now been deciphered. This
equation has many meanings such as output, national income, and GDP. It is difficult, or impossible, to
think of economic activity that is not represented in the aggregate demand equation. This is the idea of
aggregate demand: to capture all economic activity within an economy