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Answer the Following Question. State and Discuss the Components of Aggregate Demand in a Two

Answer the Following Question. State and Discuss the Components of Aggregate Demand in a Two-sector Economy.

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Answer the following question.

State and discuss the components of Aggregate Demand in a two-sector economy.

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SOLUTION

The components of Aggregate Demand in a two-sector economy are:Private consumption expenditure: Private consumption expenditure refers to the total expenditure incurred by all the households in an economy on different types of final goods and services in order to satisfy their wants. Consumption depends on the level of disposable income. It shares a positive relationship with the level of disposable income, that is, lower the level of disposable income lower will be the purchasing power and hence lower will be the consumption expenditure. The functional form that depicts the relationship between consumption expenditure and the level of disposable income is known as consumption function. There are two types of consumption expenditure- Autonomous Consumption Expenditure and Induced Consumption Expenditure. Autonomous Consumption Expenditure is independent of the level of disposable income, whereas, Induced Consumption Expenditure depends on the level of disposable income.Private investment expenditure: Private investment expenditure refers to the planned (ex-ante) total expenditure incurred by all the private investors on the creation of capital goods such as expenditure incurred on new machinery, tools, buildings, raw materials, etc. This expenditure by all the private investors on the capital goods adds to the total stock of capital thereby increases the overall productive capacity of the economy. Investment depends on the rate of interest and level of income. Broadly, the investment can be categorized into two types- Autonomous Investment Expenditure and Induced Investment Expenditure. The Autonomous Investment Expenditure is independent of the rate of interest and level of income, whereas, the Induced Investment Expenditure depends on the rate of interest and level of income.

Concept: Concept of Aggregate Demand and Aggregate Supply

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2018-2019 (March) 58/1/1

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Components of Aggregate Demand

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Components of Aggregate Demand

Last Updated : 22 Nov, 2022

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What is Aggregate Demand?

The word aggregate in the Aggregate Demand means ‘Total’, therefore, Aggregate Demand indicates the total demand of an economy. Aggregate Demand refers to the total demand for finished goods and services in the economy over a specific period. It also refers to a country’s Gross Domestic Product (GDP) demand. Aggregate demand is also known as Aggregate Expenditure (AE) as AE is the total expenditure incurred by all the sectors of the economy. The aggregate demand includes factors such as personal consumption, investment, government demand, and net exports. An economy’s aggregate demand increases when the variables’ sum increases.

Note: Aggregate Demand is not the same as Market Demand. The former is the total demand for goods and services in an economy; however, the latter is the demand for one commodity in the market.

Components of Aggregate Demand

The Aggregate Demand of an economy is typically a sum of four components; viz., Government Expenditure (G), Consumption Expenditure (C), Investment Expenditure (I), and Net Export (X – M).

1. Government Expenditure (G):

Government Expenditure is the total expenditure made by the government on the acquisition of public goods and social services to satisfy the need of the overall economy. The government expenditure includes all the consumption (C) and investment (I) expenditures like infrastructure, investments, defence and military equipment, public sector facilities, healthcare services, government employees, etc. The government expenditure, however, does not include transfer payments like pension plans, subsidies, and aid transfers to other countries. The level of Government Expenditure of an economy is determined by the government’s policy which is usually guided by social welfare.

2. Private (Household) Consumption Expenditure (C):

Consumption Expenditure or Private/Household Consumption Expenditure refers to the total spending of an individual or a household on the purchase of goods and services in an economy during an accounting year. Even though the spending of a consumer is affected by several factors like disposable income, per capita income, debt, consumer expectations of future economic conditions, and interest rates; disposable income plays a major role in it. It refers to the total income a household spends on savings and the purchase of goods and services. The spending of the households is majorly affected by disposable income as when the income of the consumer increases, the expenditure increases and vice-versa. The consumption expenditure; however, does not include spending on residential structures.

3. Investment Expenditure (I):

Investment Expenditure refers to the company’s total expenditure on acquiring new capital goods and services like machinery and equipment, changes in inventories, and investments in non-residential and residential structures. The spending depends on factors such as interest rates, future expectations of the economy, and incentives of the government, such as tax benefits or subsidies.

4. Net Export (X – M):

The term total export refers to the demand for the products that are produced by domestic producers but are sold to the rest of the world, while total import refers to the demand for the products that are manufactured outside the domestic boundaries of the country but are imported to the country. Therefore, Net export refers to the difference between the Total Export (X) and Total Import (M) of the country.

Aggregate Demand in a Two-Sector Model (AD = C + I)

Although Aggregate Demand has four elements or components, the two-sector model of aggregate demand focuses on only two components; i.e., Investment Expenditure and Consumption Expenditure. According to this,

Aggregate Demand = Consumption + Investment

Or

AD = C + I.

Diagrammatic Representation of AD

The Aggregate Demand depends on the income and expenditure of an economy. Generally, when the income of an economy rises, the expenditure also rises, and vice-versa. Considering this, it can be stated that income and expenditure have a positive relationship.

Income (Y) Consumption (C) Investment (I) AD (C + I)

0          30        30     60

100         110        30    140

200         190        30    220

300         270        30    300

400         350        30    380

500         430        30    460

Important points about AD

Aggregate Demand is the measure of the aggregate income and expenditure of an economy, i.e., AD = C + I.

There is always a minimum level of consumption irrespective of the income level, i.e., the consumption always remains positive irrespective of the income of the buyer/user. For example, in the above case, even though the Income is 0, there is a minimum level of consumption of 30. This consumption is known as Autonomous Consumption (OS). It is because people need some basic goods and services even at 0 Income to sustain themselves.

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Aggregate Demand: Formula, Components, and Limitations

Aggregate demand is a measurement of the total amount of demand for all finished goods and services produced in an economy.

ECONOMICS MACROECONOMICS

Aggregate Demand: Formula, Components, and Limitations

By WILL KENTON Updated January 04, 2023

Reviewed by MICHAEL J BOYLE

Fact checked by SUZANNE KVILHAUG

Investopedia / Ellen Lindner

What Is Aggregate Demand?

Aggregate demand is a measurement of the total amount of demand for all finished goods and services produced in an economy. Aggregate demand is commonly expressed as the total amount of money exchanged for those goods and services at a specific price level and point in time.

KEY TAKEAWAYS

Aggregate demand measures the total amount of demand for all finished goods and services produced in an economy.

Aggregate demand is expressed as the total amount of money spent on those goods and services at a specific price level and point in time.

Aggregate demand consists of all consumer goods, capital goods, exports, imports, and government spending.

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Aggregate Demand

Understanding Aggregate Demand

Aggregate demand is a macroeconomic term and can be compared with the gross domestic product (GDP). GDP represents the total amount of goods and services produced in an economy while aggregate demand is the demand or desire for those goods. Aggregate demand and GDP commonly increase or decrease together.

Aggregate demand equals GDP only in the long run after adjusting for the price level. Short-run aggregate demand measures total output for a single nominal price level without adjusting for inflation. Other variations in calculations can occur depending on the methodologies used and the various components.

Aggregate demand consists of all consumer goods, capital goods, exports, imports, and government spending programs. All variables are considered equal if they trade at the same market value.

While aggregate demand helps determine the overall strength of consumers and businesses in an economy, it does have limits. Since aggregate demand is measured by market values, it only represents total output at a given price level and does not necessarily represent the quality of life or standard of living in a society.

Aggregate Demand Components

Aggregate demand is determined by the overall collective spending on products and services by all economic sectors on the procurement of goods and services by four components:

Consumption Spending

Consumer spending represents the demand by individuals and households within the economy. While there are several factors in determining consumer demand, the most important is consumer incomes and the level of taxation.

Investment Spending

Investment spending represents businesses' investment to support current output and increase production capability. It may include spending on new capital assets such as equipment, facilities, and raw materials.

Government Spending

Government spending represents the demand produced by government programs, such as infrastructure spending and public goods. This does not include services such as Medicare or social security, because these programs simply transfer demand from one group to another.

Net Exports

Net exports represent the demand for foreign goods, as well as the foreign demand for domestic goods. It is calculated by subtracting the total value of a country's exports from the total value of all imports.

Aggregate Demand Formula

The equation for aggregate demand adds the amount of consumer spending, investment spending, government spending, and the net of exports and imports. The formula is shown as follows:

\begin{aligned} &\text{Aggregate Demand} = \text{C} + \text{I} + \text{G} + \text{Nx} \\ &\textbf{where:}\\ &\text{C} = \text{Consumer spending on goods and services} \\ &\text{I} = \text{Private investment and corporate spending on} \\ &\text{non-final capital goods (factories, equipment, etc.)} \\ &\text{G} = \text{Government spending on public goods and social} \\ &\text{services (infrastructure, Medicare, etc.)} \\ &\text{Nx} = \text{Net exports (exports minus imports)} \\ \end{aligned}

​

Aggregate Demand=C+I+G+Nx

where:

C=Consumer spending on goods and services

I=Private investment and corporate spending on

non-final capital goods (factories, equipment, etc.)

G=Government spending on public goods and social

services (infrastructure, Medicare, etc.)

Nx=Net exports (exports minus imports)

​

The aggregate demand formula above is also used by the Bureau of Economic Analysis to measure GDP in the U.S.

1

Aggregate Demand Curve

Like most typical demand curves, it slopes downward from left to right with goods and services on the horizontal X-axis and the overall price level of the basket of goods and services on the vertical Y-axis. Demand increases or decreases along the curve as prices for goods and services either increase or decrease.

What Affects Aggregate Demand?

Interest Rates

Interest rates affect decisions made by consumers and businesses. Lower interest rates will lower the borrowing costs for big-ticket items such as appliances, vehicles, and homes and companies will be able to borrow at lower rates, often leading to capital spending increases. Higher interest rates increase the cost of borrowing for consumers and companies and spending tends to decline or grow at a slower pace.

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