Aggregate Demand and its components

In macroeconomics, AD (aggregate demand) refers to demand for all goods and services in the economy during a period of time (generally, one year).

AD is measured in terms of expenditure on all the goods and services in the economy during a period of time.

Simple Keynesian model of income determination states that an economy’s total income in the short – run is determined by desired aggregate demand or aggregate spending of the people. The more is the desired demand of the people, more amount of goods and services that firms can sell. The more goods and services firms can sell, the more output they will like to produce and more workers they will employ.

Components of AD

Aggregate demand is the total amount of goods and services demanded in the economy. It refers to the desired intended or planned demand or spending by the people, i.e. the total amount of goods and services they would like to purchase.

So we consider four main groups of buyers:

1) C (Private Consumption Expenditure)

It is also called household consumption expenditure. It comprises demand for all goods and services by the households of a country during an accounting year.

Private consumption expenditure is determined by the level of personal disposable income (it is that part of personal income which is available to the individuals to be used the way they like) in the economy.

Higher the level of personal disposable income, higher the private consumption expenditure.

2) P (Private Investment Expenditure)

It refers to expenditure by private investors on the purchase of such goods which add to their stock of capital. Investment implies increase in the stock of capital, also called Capital Formation.

Rate of interest is the principal determinants of private investment. Higher rate of interest generally implies lower investment expenditure.

3) G (Government Expenditure)

It includes both government consumption expenditure and government investment expenditure.

Government consumption expenditure is the expenditure on the purchase of consumption goods, meant for collective consumption.

Government investment expenditure is like expenditure on the construction of roads, dams and bridges.

 Government investment is different from private investment. Private investment is generally induced investment, determined by considerations of profit.

Government investment is generally autonomous investment, determined by considerations of social welfare.

4) X – M (Net Export)

Export refers to demand for domestically produced goods by the rest of the world. Import refers to demand by our residents of the goods produced abroad.

Expenditure by the foreigners on our goods is added to total expenditure (or AD) in the economy, while expenditure on import is subtracted. Thus, it is X – M (net exports) which is added to AD.

Thus, the desired spending on domestically produced goods and services is called aggregate spending(AE) and can be expressed as :

AE or AD = C + I + G + ( X – M)

It should be noted that in the context of macroeconomics, C means desired private consumption expenditure, I means desired private investment expenditure, G means desired government expenditure, and X – M means desired net exports.

These are the expenditures what the households, firms, the government and rest of the world wish to make (or plan to make) on the purchase of domestically produced goods and services during an accounting year.

In the theory of Income Determination, we take each of the four categories of spending in the sense of desired spending. However in national income accounting, we take these four categories in the sense of actual spending.