25.1 Aggregate Demand in Keynesian Analysis

Aggregate demand is the total demand for goods and services in an economy. It's made up of four key components: consumption, investment, government spending, and net exports. Understanding these parts helps us grasp how the economy works as a whole.

Each component plays a unique role in shaping overall demand. Changes in any of these areas can have a big impact on the economy. For example, if people spend more, businesses invest more, or the government increases spending, it can boost economic growth.

Components of Aggregate Demand

Consumption, Investment, Government Spending, Net Exports

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• Aggregate demand ($AD$) total demand for goods and services in an economy
  • Composed of four components: consumption ($C$) spending by households, investment ($I$) spending by businesses, government spending ($G$), and net exports ($NX$) difference between exports and imports
  • Expressed as: $AD = C + I + G + NX$
• Each component contributes to overall demand for goods and services
  • Increase in any component leads to increase in aggregate demand and real GDP (measure of total economic output adjusted for inflation)
  • Decrease in any component leads to decrease in aggregate demand and real GDP

Determinants of Aggregate Demand Components

Consumption Expenditure

• Consumption ($C$) largest component of aggregate demand
• Disposable income key determinant of consumption
  • Disposable income = Income - Taxes
  • As disposable income increases, consumption tends to increase (more money available for spending)
• Marginal propensity to consume ($MPC$) measures change in consumption due to change in disposable income
  • $MPC = \frac{\Delta C}{\Delta YD}$
• Future income expectations influence consumption
  • Positive expectations (anticipation of higher future income) lead to higher current consumption
  • Negative expectations (anticipation of lower future income) lead to lower current consumption and higher saving (precautionary motive)
• Household wealth affects consumption
  • Increase in wealth (rising house prices, stock market gains) can boost consumption (wealth effect)
  • Decrease in wealth (falling house prices, stock market losses) can lead to reduction in consumption

Investment Expenditure

• Investment ($I$) purchase of capital goods (machinery, equipment, buildings)
• Expectations of future profits influence investment decisions
  • Positive expectations (anticipation of higher future profits) lead to higher investment
  • Negative expectations (anticipation of lower future profits) lead to lower investment
• Interest rates impact investment decisions
  • Lower interest rates make borrowing cheaper, encouraging investment (lower cost of capital)
  • Higher interest rates make borrowing more expensive, discouraging investment (higher cost of capital)
• Marginal efficiency of capital ($MEC$) expected rate of return on additional unit of capital
  • Firms invest when $MEC$ greater than interest rate (profitable investment opportunity)

Government Spending and Tax Policies

• Government spending ($G$) directly contributes to aggregate demand
  • Includes purchases of goods and services (defense, infrastructure), transfer payments (social security, welfare), and public investment (education, research)
• Tax policies affect aggregate demand through impact on disposable income
  • Tax cuts increase disposable income, leading to higher consumption and aggregate demand
  • Tax increases reduce disposable income, leading to lower consumption and aggregate demand
• Fiscal policy use of government spending and tax policies to influence aggregate demand
  • Expansionary fiscal policy (increasing $G$, reducing taxes) stimulates aggregate demand (boost economic growth)
  • Contractionary fiscal policy (decreasing $G$, raising taxes) reduces aggregate demand (curb inflation)

Net Exports

• Net exports ($NX$) difference between exports and imports
  • $NX = Exports - Imports$
• Domestic income affects net exports
  • Higher domestic income leads to increased demand for imports (higher purchasing power), reducing net exports
  • Lower domestic income leads to decreased demand for imports (lower purchasing power), increasing net exports
• Foreign income affects net exports
  • Higher foreign income leads to increased demand for domestic exports (higher purchasing power of trading partners), increasing net exports
  • Lower foreign income leads to decreased demand for domestic exports (lower purchasing power of trading partners), reducing net exports
• Relative prices (exchange rates) influence net exports
  • Appreciation of domestic currency (increase in value relative to foreign currencies) makes exports more expensive and imports cheaper, reducing net exports
  • Depreciation of domestic currency (decrease in value relative to foreign currencies) makes exports cheaper and imports more expensive, increasing net exports