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1. What is aggregate demand?

Aggregate demand is an economic measurement of the sum of all final goods and
services produced in an economy, expressed as the total amount of money
exchanged for those goods and services. Since aggregate demand is measured
through market values, it only represents total output at a given price level, and does
not necessarily represent quality or standard of living.
Read more: Aggregate Demand Definition |
Investopedia http://www.investopedia.com/terms/a/aggregatedemand.asp#ixzz4IbiM
arfm

Total level of demand for desired goods and services (at any time by all groups within a
national economy) that makes up the gross domestic product (GDP). Aggregate demand is
the sum of consumption expenditure, investment expenditure, government expenditure, and
net exports.
Read more: http://www.businessdictionary.com/definition/aggregate-demand.html

Aggregate demand (AD) is the total demand by domestic and foreign


households and firms for an economy's scarce resources, less the
demand by domestic households and firms for resources from abroad.
http://www.economicsonline.co.uk/Managing_the_economy/Aggregate_deman
d.html

2. Explain demand curve and different shift.

5.2 Aggregate Demand


The aggregate demand curve (AD) describes the total volume of aggregate
expenditures in the economy at different price levels. (Given equilibrium in the
underlying goods and money markets from which equilibrium levels of expenditure
are derived.)
Thus, the AD describes the aggregate expenditure-price outcomes in the economy. At
each point on the AD curve, the underlying goods and money markets are in
equilibrium for that price level.
That's a lot of abstract words. Let's try a more specific question:
As the price level changes, how does equilibrium aggregate expenditure as
determined in goods and money markets change as prices change? We're going to

assume that Ms, G, and T are fixed. What we want to know is, with these things fixed,
how will AD change as P changes?
What does P (the price level) affect? First, remember that your transactions demand
for money depends on Y, r and P. When prices decrease, the demand for money
balances decreases, and when prices increase, the demand for money balances
increases. (Go back to section 3.2 if you've forgotten this.)
So if P rises Md rises, if P falls Md falls. If Md rises, r rises and Ip falls. If Md falls, r
falls and Ip rises.
So we've found a connection through the demand for money balances:
If P increases, Md increases, r rises, Ip falls and hence AD falls.
If P falls, Md falls, r falls, Ip rises and hence AD rises.
There are two additional reasons that we expect aggregate expenditures in the goods
market to increase as the price level drops. Both involve slightly fancier theory than
we've been using so far.
The first additional reason is that as P falls, causing Md to decrease and r to decrease,
the impact of a fall in r might be felt not only in planned investment (Ip) but also in
consumption (C).
As the interest rate falls, consumers may decide that it is not worth it to save as much
at the going income level (since they do not receive as much return when they take
these savings to bond markets), or decide that since it is now cheaper to borrow, they
will consume more and borrow from credit card companies to finance this
consumption. Thus, as r decreases, we might expect to see C rise as well, adding to
the increase in expenditures generated by P decreasing. (Obviously now C is not just a
function of Y, but is affected by r too, making our model more complicated.)
The second additional reason has to do with "wealth effects." If goods prices fall but
the value of your assets don't, you feel wealthier and may start consuming more.
Additionally if r falls, the value of any bonds you hold rises, and that will make you
feel wealthier, and you'll consume more.
So we've provided three reasons why a fall in the price level might induce a larger
amount of aggregate expenditures.

Graphically, this is a way of saying that the AD curve slopes down as a function of
the price level.
Having shown that AD slopes down as a function of P, we need to see how it will
shift as one of the factors we have held constant (G, T, or Ms) changes.
We already know from our previous analysis that:
a) an increase in G
b) a decrease in T
c) an increase in Ms
Will cause Y to increase at the going price level.
Thus, if G increases, T decreases, or Ms increases, Y increases at the current price
level -- graphically, the AD curve shifts out.
Similarly, a decrease in G, an increase in T, or a decrease in Ms will cause AD to shift
in.
http://faculty.washington.edu/danby/notes/notes14.html

In macroeconomics, the focus is on the demand and supply of all goods and services
produced by an economy. Accordingly, the demand for all individual goods and services
is also combined and referred to asaggregate demand. The supply of all individual
goods and services is also combined and referred to as aggregate supply. Like the
demand and supply for individual goods and services, the aggregate demand and
aggregate supply for an economy can be represented by a schedule, a curve, or by an
algebraic equation

The aggregate demand curve represents the total quantity of all goods (and services)
demanded by the economy at differentprice levels. An example of an aggregate demand
curve is given in Figure .

The vertical axis represents the price level of all final goods and services. The
aggregate price level is measured by either the GDP deflator or the CPI. The horizontal
axis represents the real quantity of all goods and services purchased as measured by
the level of real GDP. Notice that the aggregate demand curve, AD, like the demand
curves for individual goods, is downward sloping, implying that there is an inverse
relationship between the price level and the quantity demanded of real GDP.
The reasons for the downwardsloping aggregate demand curve are different from the
reasons given for the downwardsloping demand curves for individual goods and
services. The demand curve for an individual good is drawn under the assumption that
the prices of other goods remain constant and the assumption that buyers' incomes
remain constant. As the price of good X rises, the demand for good X falls because the
relative price of other goods is lower and because buyers' real incomes will be reduced
if they purchase good X at the higher price. The aggregate demand curve, however, is
defined in terms of the price level. A change in the price level implies that many prices
are changing, including the wages paid to workers. As wages change, so do incomes.
Consequently, it is not possible to assume that prices and incomes remain constant in
the construction of the aggregate demand curve. Hence, one cannot explain the
downward slope of the aggregate demand curve using the same reasoning given for the
downwardsloping individual product demand curves.

Reasons for a downwardsloping aggregate demand curve. Three reasons cause


the aggregate demand curve to be downward sloping. The first is the wealth effect. The
aggregate demand curve is drawn under the assumption that the government holds
the supply of money constant. One can think of the supply of money as representing
the economy's wealth at any moment in time. As the price level rises, the wealth of the
economy, as measured by the supply of money, declines in value because the
purchasing power of money falls. As buyers become poorer, they reduce their
purchases of all goods and services. On the other hand, as the price level falls, the
purchasing power of money rises. Buyers become wealthier and are able to purchase
more goods and services than before. The wealth effect, therefore, provides one reason
for the inverse relationship between the price level and real GDP that is reflected in the
downwardsloping demand curve.
A second reason is the interest rate effect. As the price level rises, households and
firms require more money to handle their transactions. However, the supply of money is
fixed. The increased demand for a fixed supply of money causes the price of money,
the interest rate, to rise. As the interest rate rises, spending that is sensitive to rate of
interest will decline. Hence, the interest rate effect provides another reason for the
inverse relationship between the price level and the demand for real GDP.
The third and final reason is the net exports effect. As the domestic price level rises,
foreignmade goods become relatively cheaper so that the demand
for imports increases. However, the rise in the domestic price level also means that
domesticmade goods are relatively more expensive to foreign buyers so that the
demand for exports decreases. When exports decrease and imports increase, net
exports (exports imports) decrease. Because net exports are a component of real
GDP, the demand for real GDP declines as net exports decline.
Changes in aggregate demand. Changes in aggregate demandare represented by
shifts of the aggregate demand curve. An illustration of the two ways in which the
aggregate demand curve can shift is provided in Figure .

A shift to the right of the aggregate demand curve. from AD 1 to AD 2, means that at the
same price levels the quantity demanded of real GDP has increased. A shift to the left of
the aggregate demand curve, from AD 1 to AD 3, means that at the same price levels the
quantity demanded of real GDP has decreased.

Changes in aggregate demand are not caused by changes in the price level. Instead,
they are caused by changes in the demand for any of the components of real GDP,
changes in the demand for consumption goods and services, changes in investment
spending, changes in the government's demand for goods and services, or changes in
the demand for net exports.
Consider several examples. Suppose consumers were to decrease their spending on all
goods and services, perhaps as a result of a recession. Then, the aggregate demand
curve would shift to the left. Suppose interest rates were to fall so that investors
increased their investment spending; the aggregate demand curve would shift to the
right. If government were to cut spending to reduce a budget deficit, the aggregate
demand curve would shift to the left. If the incomes of foreigners were to rise, enabling
them to demand more domesticmade goods, net exports would increase, and
aggregate demand would shift to the right. These are just a few of the many possible

ways the aggregate demand curve may shift. None of these explanations, however, has
anything to do with changes in the price level.
https://www.cliffsnotes.com/study-guides/economics/aggregate-demand-andaggregate-supply/aggregate-demand-ad-curve

Shifts in the Aggregate Supply-Aggregate Demand Model


The aggregate supply-aggregate demand model uses the theory of supply and demand in order to find
a macroeconomic equilibrium. The shape of the aggregate supply curve helps to determine the extent
to which increases in aggregate demand lead to increases in real output or increases in prices. An
increase in any of the components of aggregate demand shifts the AD curve to the right. When the AD
curve shifts to the right it increases the level of production and the average price level. When an economy
gets close to potential output, the price will increase more than the output as the AD rises .

AS-AD Model
The Aggregate Supply-Aggregate Demand Model shows how equilibrium is determined
by supply and demand. It shows how increases and decreases in output and prices
impact the economy in the short-run and long-run. The model is also used to show real
and potential output.
When price increase dominates an economy, this means that the economy is near its potential output.
Reasons for Aggregate Demand Shift
The slope of the aggregate demand curve shows the extent to which the real balances change the
equilibrium level of spending. The aggregate demand curve shifts to the right as a result of monetary
expansion. In an economy, when the nominal money stock in increased, it leads to higher real money
stock at each level of prices. The interest rates decrease which causes the public to hold higher real
balances. This stimulates aggregate demand, which increases the equilibrium level of income and
spending. Likewise, if the monetary supply decreases, the demand curve will shift to the left.

Source: Boundless. Reasons for and Consequences of Shift in Aggregate Demand. Boundless
Economics. Boundless, 26 May. 2016. Retrieved 28 Aug. 2016
from https://www.boundless.com/economics/textbooks/boundless-economics-textbook/aggregatedemand-and-supply-24/the-aggregate-demand-supply-model-110/reasons-for-and-consequences-of-shiftin-aggregate-demand-422-12519/

3. Identify or enumerate the four components of Aggregate demand.

CONSUMPTION

his is made by households, and sometimes consumption accounts for the larger portion of

aggregate demand. An increase in consumption shifts the AD curve to the right.

FACTORS THAT AFFECT CONSUMPTION

CONSUMER CONFIDENCE

If consumers are confident about their future income, job stability, and the economy is growing and
stable, spending is likely to increase. However, any job insecurity and uncertainty over income is
likely to delay spending. An increase in consumer confidence shifts AD to the right.
INTEREST RATES
Lower interest rates tend to increase consumption because larger goods are usually purchased on
credit and if interest rates are low, then its cheaper to borrow. Consumers mostly borrow to
buy houses, which is one of the biggest purchases and lower interest rates means lower mortgage
payments, so households can spend more on other goods. Some Economists argue that lower interest
rates also make saving less attractive, but there is no real evidence. So, lower interest rates increase
Aggregate Demand.
CONSUMER DEBT
If a consumer has a lot of debt, he is unlikely to buy more since he would have to pay his debt off
first. Low consumer debt increases consumption and aggregate demand.

WEALTH
Wealth are assets held by a household, such as property or stocks. An increase in property is likely
increase to consumption.

INVESTMENT

nvestment, second of the four components of aggregate demand, is spending by firms on capital,

not households. Investment is the most volatile component of AD. An increase in investment shifts
AD to the right in the short run and helps improve the quality and quantity of factors of
production in the long run.

FACTORS THAT AFFECT INVESTMENT:


INTEREST RATES

Firms borrow from banks to make large capital intensive purchases, and if the interest rate
decreases, it becomes cheaper for firms to invest and provides incentive for firms to take risk.
BUSINESS CONFIDENCE
If firms are confident about the economy and its future growth, they are more likely to invest in
capital, new projects and buildings/machinery.
INVESTMENT POLICY
If governments provide incentives such as tax breaks, subsidies, loans at lower interest rates then
investment can increase. However, corruption and bureaucracy deters investment.
NATIONAL INCOME
As firms increase output, they would need to invest in new machines. This relationship is known
as The Accelerator. The assumption behind the accelerator is that firms will want to main a fixed
capital to output ratio, meaning that if a factory uses one machine to produce 1000 goods, and the
firms needs to produce 3000 goods more, then the firm will buy 3 more machines.

GOVERNMENT SPENDING

overnment spending forms a large total of aggregate demand, and an increase in government

spending shifts aggregate demand to the right. Government spending is categorized into transfer
payments and capital spending. Transfer payments include pensions and unemployment benefits
and capital spending is on things like roads, schools and hospitals. Governments spend to increase
the consumption of health services, education and to re-distribute income. They may also spend
to increase aggregate demand.

NET EXPORTS

mports are foreign goods bought by consumers domestically, and exports are domestic goods

bought abroad. Net exports is the difference between exports and imports, and this component can
be net imports too, if imports are greater than exports. An increase in net exports shifts aggregate
demand to the right. The exchange rate and trade policy affects net exports.

https://www.intelligenteconomist.com/components-of-aggregate-demand/

C= Consumer spending (Household consumption)

I = Investment (gross fixed capital formation)

G= Government spending (Government investment and Government


consumption)

X-M = Net Exports.


http://www.economicshelp.org/blog/5301/economics/components-of-aggregatedemand/

Aggregate means total and in this case we use the term to measure how much is
being spent by all consumers, businesses, the government and people and firms
overseas.
Aggregate demand (AD) = total spending on goods and services
The formula for calculating aggregate demand is as follows:
AD = C + I + G + (X-M)
C: Consumers' expenditure on goods and services: Also known as consumption, this
includes demand for durables e.g. audio-visual equipment and vehicles & non-durable
goods such as food and drinks which are consumed and must be re-purchased.
I: Capital Investment This is spending on capital goods such as plant and equipment
and new buildings to produce more consumer goods in the future. Investment includes
spending on working capital such as stocks of finished and semi-finished goods.
Capital investment spending in the UK accounts for between 15-20% of GDP in any
given year. Of this investment, 75% comes from private sector businesses such as
Tesco, British Airways and British Petroleum and the remainder is spent by the
government for example building new schools or in improving rail or road networks.
Investment has important effects on the supply-side as well as being an important
component of AD.
A small part of investment spending is the change in the value of stocks. Producers may
find either than demand is running higher than output (i.e. stocks will fall) or that
demand is weaker than expected and below current output (in which case the value of
stocks will rise.)
G: Government Spending This is spending on state-provided goods and services
including public goods and merit goods. Decisions on how much the government will
spend each year are affected by developments in the economy and the political
priorities of the government.
Government spending on goods and services is around 18-20% of GDP but this tends
to understate the true size of the government sector in the economy. Firstly some
spending is on investment and a sizeable amount goes on welfare state payments.

Transfer payments in the form of benefits (e.g. state pensions and the job-seekers
allowance) are not included in current government spending because they are a transfer
from one group (i.e. people paying income taxes) to another (i.e. pensioners drawing
their state pension having retired, or families on low incomes).
X: Exports of goods and services - Exports sold overseas are an inflow of demand (an
injection) into our circular flow of income and spending adding to aggregate demand.
M: Imports of goods and services. Imports are a withdrawal of demand (a leakage) from
the circular flow of income and spending.
Net exports measure the value of exports minus the value of imports. When net exports
are positive, there is a trade surplus (adding to AD); when net exports are negative,
there is a trade deficit (reducing AD). The UK has been running a large trade deficit for
several years now.
http://www.tutor2u.net/economics/reference/aggregate-demand-ad

4. Identify or enumerate the five components of Consumption

Significance
Consumption is the value of goods and services bought by
people. Individual buying acts are aggregated over time and
space.
Consumption is normally the largest GDP component. Many
persons judge the economic performance of their country mainly
in terms of consumption level and dynamics.
Composition
First, consumption may be divided according to the durability of the
purchased objects. In this vein, a broad classification
separates durable goods (as cars and television sets) from nondurable goods
(as
food)
and from services (as
restaurant

expenditure). These three categories often show different paths of


growth.
Second, consumption is divided according to the needs it
satisfies. A commonly used classification identifies tenchapters of
expenditure:
1. Food
2.
Clothing
and
3.
4.
Heating
5. Health
6.
7.
House
furniture
8.
9.
Culture
10. Entertainment

foot

and
and

wear
Housing
and energy
Transport
appliances
Communication
schooling

People in different position in respect to income have


systematically different structures of consumption. The richspend
more for each chapter in absolute terms, but they spend a lower
percentage in income for food and other basic needs. The
percentage values of an aggregation over all the households in a
country can thus be used for judging income distribution and
the development level of the society.
The rich have both higher levels of consumption and savings.
In differentiated product markets, the rich can usually buy better
goods than the poor. This happens also because they tend to use
different decision making rules. In certain conditions, the poor can
pay more than the rich to satisfy the same need. In other words,
consumption depends on social groups and their behaviours, as well
as their proneness to advertising.

Third, one should distinguish "consumption" as use of goods and


services from "consumption expenditure" as buyingacts. For
durable goods this difference is very relevant, since they are used
for long time periods.
In this vein, the rich have a much wider cumulative bundle of
durable goods purchased over time, so they enjoy a very
significantly higher degree of need satisfaction, whereas the poor
can suffer deficiencies even in the most basic goods.
Conversely, purchased non-durable goods that are not consumed
before the deadline are a typical waste (and squander).
Fourth, only newly produced goods enter into the definition of
consumption, wheareas the purchase of, say, an old house is not
considered consumption in macroeconomics, since it was already
counted in the GDP of the year in which it was built. Needless to
say, for the consumer, both old and new goods provides some need
satisfaction.
In microeconomic terms, total consumption expenditure of one
household is the sum, over a span of time and across allcategories,
of the value (i.e. price times quantity) of all varieties of goods and
services purchased, where the quantity purchased depends on the
consumption average dose times the number of consumption
occasions (i.e. seized consumption opportunities). Macroeconomic
consumption is the sum of the consumption of all households,
keeping into account that households are not independent from
each other but rather communicate and co-variate.
Conversely, consumption is the value of domestic and foreign
firms' sales in the domestic market to households (thus
excluding business investment and public expenditure).
Determinants

Current income level and dynamics is the most relevant


determinant of consumption. Income comes from labour
(employment and wages), capital (e.g. profits leading to dividends,
rents,
etc.), remittances from
abroad.
Income
from
consumer's cumulative bundle (including dividends and interests on
wealth) provides an additional flow to available income.
Cumulated savings in the past can be squeezed in case of
necessity and give rise to a jump in consumption, similarly with
what happens with wealth increase, due for instance to stock
exchange boom or house prices boom. Family debt can be boosted
to fund consumption, while repayments brake its dynamics.
Expectations on future income, especially if concerning short-term
credible events, may also play an important role.
At household level, there are many possible rules set to control
monthly, weekly or even daily consumption expenditure, resulting
from empirical
and
theoretical
approaches
to
consumers.
These routines relate not only to income but also to the following
factors among others:
1. general lifestyles, in particular attitudes toward savings or
consumption
and
shopping
as
"values"
in
itself;
2. a standard level of consumption the family tries to maintain
over
time;
3. decisions regarding active saving strategies, like an
investment
scheme
for
pension
aims;
4. the relative success of past investment in shares or other
financial instruments; in fact, a housing, a real estate or astockexchange boom are likely to promote an euphoria tide with
growing
consumption;
5. opportunities of consumer credit, depending in turn by interest
rates and marketing strategies by banks and special consumer
credit
institutions;

6. past decisions on durables. For instance, a family having


bought a car will reduce expenditure on public transport in favour
e.g.
of
fuel;
7. status symbols diffusion - "social musts" - that can be favoured
by a
pro-diffusion-of-innovation
tax ;
8. new employment perspectives,
also
as
far
as
the
corresponding investments in human and physical capital are
concerned;
9. innovative sale proposals in terms of both new products and new
services,
effectively advertised;
10.
temporary money (cash)
excess;
11. family debt management, with repayments tightening
consumption;
12. fiscal conditions, with particular tax and subsidies impacting the
timing and the amount devoted to purchases; VAT expected
increases, for instances, might lead to anticipation to purchases.
According to age of the decision-maker, individual and household
consumption varies, both in values and composition. Thus,
aggregate consumption may be influenced by demographic factors,
such as an older and older population, even though one should not
rely too much on these relationships since demographic variables
are extremely slow in changes, whereas consumption clearly
reacts to economic climate.
Other things equal, a higher price level (inflation) reduces the
real current income, thus real consumption.
Impact on other variables
A GDP component as it is, consumption has an immediate impact on
it. An increase of consumption raises GDP by the same
amount, other things equal. Moreover, since current income
(GDP) is an important determinant of consumption, the increase of
income will be followed by a further rise in consumption:

a positive feedback loop has been triggered between consumption


and income.
An autonomous increase of consumption, if at the same level of
income, would reduce savings, but the positive loop just described
(known as the "Keynesian multiplier") will imply an increase of
income level with a positive impact on future savings.
If directed to goods and services produced abroad, an increase of
consumption will immediately push up imports, while a similar
indirect effect will result from consuming domestic products
requiring foreign raw materials, energy, semi-manufactured goods.
Since usually the States separately tax consumption (say with a
VAT tax), an increase of consumption will also boost this type
of State revenue, as well as import duties revenue in the case of
imported goods. The growth mechanism of consumption-income will
also provide State revenue through income taxes.
To the extent firms decide to invest by forecasting future demand
and by comparing it with present production capacity, an increase of
consumption may induce new investment. In particular:
1. soaring consumption raises the production capacity utilization,
with
positive
effects
on profits;
2.
it
improves
expectations
on
future
demand;
3. it improves the financial conditions for funding investment both
through profits and loans.
If exports are a second-best solution for domestic firm, an
increase of domestic consumption might decrease export, since at
the same level of production firms would prefer to sell inside the
country. To verify this by yourself, try and play "You are an
exporter".

Consumer dissatisfaction with current products can lead to faster


adoption of new products, thus intertwining the whole new product
development cycle.
An increased total market demand may induce firms to increase
prices, the more so when they operate at full production capacity or
they operate on monopolized markets. Thus increased price
level and accelerated inflation can be an effect of booming
consumption.
Consumption can lead to CO2 emissions in the atmosphere, thus
contributing to climate change.
Long-term trends
In Western countries, consumption has always grown in the last
50 years, except in few deep recessions. Its growth
issmoother than investment's rise or net exports' growth. In
particular, services have always systematically grown at a fairly
steady pace, non-durables have often mirrored the business cycle
and durables have often over-shot the fluctuations in GDP.
Sustainable lifestyles, based on satisfaction of basic needs, green
consumer goods, dematerialisation, and carbon footprint off-setting,
will be more and more relevant in the future.
Business cycle behaviour
As the main component of GDP, it is pro-cyclical almost by
definition: any large fall in consumption would reduce GDP.
Consumption has a smoother dynamics than GDP. During
a recovery, it sustains and stabilises the trend. Durable goods,
however, are strongly pro-cyclical and they may peak shortly before
GDP.

Particular tax reductions and subsidies can be directed to


temporarily sustain sales in order to promote extraordinary
purchases. If large enough, they may help in economic turn-around
from recession to recovery. Cars and house-related large
expenditures have been often targeted, with green goods possibly
engendering further benefits to climate change mitigation.
http://www.economicswebinstitute.org/glossary/cons.htm

5. Identify or enumerate the two components of Investment.

6. Identify or enumerate the two components of Government Spending

Central and local government (public sector)


spending
Using public spending to stimulate economic activity has been a key option for
successive governments since the 1930s when British economist, John
Maynard Keynes, argued that public spending should be increased when
private spending and investment were inadequate. There are two types of
spending:
1. Current spending, which is expenditure on wages and raw materials.
Current spending is short term and has to be renewed each year.
2. Capital spending, which is spending on physical assets like roads,
bridges, hospital buildings and equipment. Capital spending is long term
as it does not have to be renewed each year - it is also called spending
on social capital.
http://www.economicsonline.co.uk/Global_economics/Fiscal_policy_governmen
t_spending.html

7. Identify or enumerate the three components of net export

1. Household (or Private) Consumption Demand (C):


It is defined as Value of goods and services that households are able
and willing to buy. Alternatively, it refers to ex-ante (planned)
consumption expenditure to be incurred by all households on
purchase of goods and services. For instance, households demand for
food, clothing, housing, books, furniture, cycles, radios, TV sets,
educational and medical services will be called household
consumption demand. Consumption (C) is a function (f) of disposable
income (Y), i.e., C =J(Y) (for detail refer Section 8.6).
As disposable income increases, consumption expenditure also
increases but by how much? It depends upon propensity to consume.
The relationship between income and consumption is called
propensity to consume or consumption function. Consumption
function is represented by the equation. (For details see Section 8.6)
2. Private Investment Demand (I):
This refers to planned (ex-ante) expenditure on creation of new capital
assets like machines, buildings and raw materials by private
entrepreneurs. Remember, investment in Keynesian sense does not
imply purchase of existing shares or securities but means expenditures
on creation of new capital assets such as plants and equipment,
inventories, construction works, etc. that help in production.
Investment is made not only to maintain present level of production,
but also to increase production capacity in future.

An economy grows through investment. Among three categories of


investment, namely, purchase of new buildings, addition to stock and
investment in fixed plant or machinery, the investment demand is
focussed on last category, i.e., machinery.
The relationship between investment demand and rate of interest is
called investment demand function. There is inverse relationship
between rate of interest and investment demand. Investment is of two
typesAutonomous and Induced (see Section 8.11) but all private
investment expenditure is assumed as induced investment.
What determines investment in private enterprise economy? Just as
household consumption demand depends on disposable income of
households, investment demand in private enterprise economy
depends mainly on two factors, namely, MEI {Marginal Efficiency of
Investment) and Rate of Interest. In other words, the investors Judge
whether the expected rate of return on new investment is equal to or
greater than or less than the market rate of interest.
Suppose a businessman makes an additional investment by taking
loan. He has to pay interest on it which is his expenditure on new
investment. Before making investment, he would compare the interest
he has to pay on loan and the profit he is expected to get on this
investment. According to Keynes, the net return expected from a new
unit of investment is called Marginal Efficiency of Investment (MEI).
Thus, three elements which are important in understanding
investment are:
(i) Revenue (i.e., rate of return on new investment)

(ii) Cost (i.e., rate of interest)


(iii) Expectations (of profit)
Investment demand function:
Of the three elements which affect investment, rate of interest is the
most important. The relationship between investment demand and
rate of interest is called investment demand function. There is inverse
relationship between the rate of interest and investment demand, i.e.,
higher the rate of interest, the lower will be the investment demand.
3. Government Demand for Goods and Services (G):
It refers to government planned (ex-ante) expenditure on purchase of
consumer and capital goods to fulfill common needs of the society.
The level of government expenditure is determined by government
policy Present-day states are by and large welfare states wherein
government participation in economic welfare of the people has
increased manifold.
Government demand may be for satisfying public needs for roads,
schools, hospitals, water works, railway transport or for infrastructure
(like roads, bridges, airports), maintenance of law and order and
defence from external aggression. Investment can be induced and
autonomous.
It needs to be noted that whereas investment in private sector is made
with profit motive and, therefore, called induced investment,
government investment is guided by peoples welfare motive and,
therefore, called autonomous investment. Since investment

expenditure is assumed to be autonomous, graphically investment


curve is a horizontal line parallel to x-axis as shown as RI in Fig. 8.1.
4. Net Exports (Exports-Imports) Demand:
Net export is the difference between export of goods and services and
import of goods and services during a given period. Net exports reflect
the demand of foreign countries for our goods and services over our
demand for foreign countries goods and services. Thus, net exports
show expected (ex-ante) net foreign demand.
This strengthens the income, output and employment process of our
economy. As against it, imports from abroad drive out the earning of
the economy and, therefore, they do not encourage domestic output
and employment.
There are many factors which influence the volume of net foreign
demand such as foreign exchange rates, terms of trade, trade policy of
the importing and exporting countries, relative prices of goods,
incomes of the nations, balance of payment position, types of
exchange control, etc. Since net exports or foreign expenditure on our
goods and services constitute a small proportion of the total
expenditure (or aggregate demand), this constituent of net exports is
usually ignored.

In sum, aggregate demand is the sum of the above- mentioned four


types of demand (expenditure), i.e., AD = C + 1 + G + (X-M). Since
determination of income (output) and employment is to be studied in
the context of a two sector (Household and Firm) economy we shall,
therefore, include in aggregate demand (AD) only two broad
components of demand such as consumption demand (C) and
investment demand (I). Put in symbols:
AD = C + I
This has been depicted in Fig. 8.1. Aggregate demand curve has been
shown as sum of consumption (C) and investment (I).
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