Posted by Anjali Kaur on Sep 21, 2020

Aggregate demand

Aggregate demand is an important element for determining the income level, consumption expenditure, investment expenditure, government expenditure, and net exports. In this post, we will focus on the aggregate demand function, its curve, and its features. Let’s learn more about it.

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Meaning of Aggregate Demand

AD is measured in terms of total expenditure on goods and services in the economy during a period of time, generally 1 year.

Even though AD has 4 components but we will assume that we have only 2 sectors; the household sector and the producer sector.

The household sector does the consumption expenditure, and the producer sector does investment expenditure.

AD = C + I

Where AD stands for aggregate demand,

C stands for consumption expenditure

I stands for investment expenditure

AD is dependent on the level of income in the economy (national income) and there exists a positive relationship between income and the level of aggregate demand (or aggregate expenditure) in the economy.

Aggregate demand components

The components or parts of the aggregate demand are the following:

AD = C + I + G + NX;

AD – Aggregate demand

C – Consumption expenditure

I – Investment expenditure

G- Government expenditure

NX – Net exports

Note: We will be assuming the 2 sector model, that is, only C and I will be considered as a part of aggregate demand, and G and NX are kept constant.

Let’s understand consumption expenditure first.

What is consumption expenditure?

Consumption expenditure means how much people are spending on buying commodities for their use.

C = c + bY

Let’s discuss these components in details:

1. Autonomous Consumption, c

Autonomous consumption means, that part of the consumption which is independent of the income level.

When I say independent, it means it does not depend on income. Some level of consumption will always be done irrespective of the income, it is necessary for the survival of the human.

2. Marginal Propensity To Consume, b

It refers to that part of the consumption which is dependent on the income level of the consumer. This is also called the slope of the consumption expenditure curve and is also known by the marginal propensity to consume.

This part has a direct or positive relation with the income level of the consumer. That is why the Consumption expenditure curve is upward.

3. National income, Y

The consumption expenditure curve does not start from the origin because of the autonomous consumption level. Have a look at the consumption expenditure curve:

What is investment expenditure?

Investment expenditure is that which is done on investing the income to earn a return on it.

We also assume that investment expenditure is autonomous that is, independent of the level of income.

I = Autonomous Investment Expenditure

Since autonomous investment expenditure are independent of the level of income in the economy. It looks like the horizontal curve parallel to the x-axis. As shown below:

The Aggregate demand or the Aggregate expenditure curve

After understanding the components and shape of the components of aggregate demand. Now, we will combine consumption expenditure, investment expenditure, the aggregate demand and we will analyze the relationship between them.

Let’s assume that we have Y, C, I and AD as below:

Y (Income)CIAD = C+I
040 (Autonomous)2060
10012020140
20020020220
30028020300
40036020380

If you plot the above data, then:

Let’s have a look at the aggregate demand curve

  1. AD is parallel to the Consumption expenditure curve.
  2. The consumption expenditure curve will never start from the origin because at 0 levels of income, we have autonomous consumption expenditure.
  3. The investment curve is a straight line parallel to the x-axis.
  4. C and I are never equal
  5. The slope of the consumption expenditure curve is upward sloping until people don’t start to save.
  6. AD is also positively sloped indicating a positive relationship between income and aggregate demand.

That’s all for today!

Thank You for reading.

You can read the related post on macroeconomics:

Introduction To Money

Central bank and its function

Process of credit creation

Precautions while calculating the national income

Real and nominal GDP

National income

National income formula list

Value-added method

Income method

Expenditure method

GDP and welfare

Domestic territory and national residents

Circular flow of income

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