Aggregate demand and its components Essay Example | Topics and Well Written Essays - 1250 words

Aggregate demand and its components - Essay Example This essay is an attempt to figure out the constituents of aggregate demand and how they interact to determine the national income. The main focus of this essay is Keynesian economics and how aggregate demand is determined in Keynesian economics. A basis proposition of Keynesian theory is that the equilibrium level of income and output depends on the economy’s aggregate spending for output. If aggregate spending is excessive, it results in inflation. My goal in this essay is to figure out how national income is determined through aggregate demand and what is the impact of aggregate demand on other major macro economic variables. Introduction In national income determination, aggregate demand plays a vital role. The first major objective of any economy is to increase and sustain its national income, an analysis of aggregate demand is very important. By controlling the aggregate demand, you can control the major economic variables. Aggregate demand is the total demand in an econ omy for all the goods and services produced. It consists of : Consumption expenditure, Investment expenditure Government expenditure Net export Aggregate demand = C+ I+ G+ (X-M) The following sections analysis each of these variables in detail: Consumption Expenditure Consumption expenditure depends on the real income of the house hold. An increase in the real income of the household leads to an increase in the consumption expenditure and a reduction in the real income of the household results in a reduction in consumption expenditure. ... tion expenditure, Keynes gave priority to consumption function which is a mathematical function showing the relationship between consumption expenditure and income. As income increases, people set aside a portion of their income for their future needs. In other words, as income increases, savings also increase. Even though the consumption increases as the income increase, the rate of increase is less. But, as the income increases, the savings increase at an increasing rate. It means, the individual set aside a larger portion of his income for savings and a smaller portion of consumption. Keynes considered consumption function as constant in the short term. The change in consumption is always greater than zero and less than one. It means, whenever there is a change in income, people won’t spent the whole amount on consumption. Investment Expenditure Keynes gave more importance to investment demand than consumption demand. The investment demand depends on two things: 1) Marginal efficiency of capital 2) Rate of interest Out of these two, rate of interest is usually stable in the short run (changes based on the policy of the central bank). So the investment demand depends largely on marginal efficiency of capital. The marginal efficiency of capital means the expected rate of profit that the investor hopes to make from the investment in capital assets. The marginal efficiency of capital depends up on the replacement cost of capital goods and profit expectations of investors. As there is no replacement in the short run, the investment in short run mainly depends on profit expectations. To increase national income and employment, government should take those measures which increase investment. So, the investment demand depends on the marginal efficiency of capital and