Aggregate Demand - Components

Components

An aggregate demand curve is the sum of individual demand curves for different sectors of the economy. The aggregate demand is usually described as a linear sum of four separable demand sources.

where

• is consumption (may also be known as consumer spending) = ,
• is Investment,
• is Government spending,
• is Net export,
  • is total exports, and
  • is total imports = .

These four major parts, which can be stated in either 'nominal' or 'real' terms, are:

• personal consumption expenditures (C) or "consumption," demand by households and unattached individuals; its determination is described by the consumption function. The consumption function is C= a + (mpc)(Y-T)
  • a is autonomous consumption, mpc is the marginal propensity to consume, (Y-T) is the disposable income.

• gross private domestic investment (I), such as spending by business firms on factory construction. This includes all private sector spending aimed at the production of some future consumable.
  • In Keynesian economics, not all of gross private domestic investment counts as part of aggregate demand. Much or most of the investment in inventories can be due to a short-fall in demand (unplanned inventory accumulation or "general over-production"). The Keynesian model forecasts a decrease in national output and income when there is unplanned investment. (Inventory accumulation would correspond to an excess supply of products; in the National Income and Product Accounts, it is treated as a purchase by its producer.) Thus, only the planned or intended or desired part of investment (I_p) is counted as part of aggregate demand. (So, I does not include the 'investment' in running up or depleting inventory levels.)
  • Investment is affected by the output and the interest rate (i). Consequently, we can write it as I(Y,i). Investment has positive relationship with the output and negative relationship with the interest rate. For example, an increase in the interest rate will cause aggregate demand to decline. Interest costs are part of the cost of borrowing and as they rise, both firms and households will cut back on spending. This shifts the aggregate demand curve to the left. This lowers equilibrium GDP below potential GDP. As production falls for many firms, they begin to lay off workers, and unemployment rises. The declining demand also lowers the price level. The economy is in recession.

• gross government investment and consumption expenditures (G).
• net exports (NX and sometimes (X-M)), i.e., net demand by the rest of the world for the country's output.

In sum, for a single country at a given time, aggregate demand (D or AD) = C + I_p + G + (X-M).

These macrovariables are constructed from varying types of microvariables from the price of each, so these variables are denominated in (real or nominal) currency terms.