25.1 Aggregate Demand in Keynesian Analysis

Components of Aggregate Demand

Aggregate demand (AD) is the total spending on goods and services in an economy. In Keynesian analysis, understanding what drives AD is central because Keynes argued that fluctuations in aggregate demand are the primary cause of economic booms and recessions. AD breaks down into four components: consumption, investment, government spending, and net exports.

$AD = C + I + G + NX$

Each component contributes to total spending. An increase in any one of them raises aggregate demand and pushes real GDP (total economic output adjusted for inflation) upward. A decrease in any component does the opposite. The sections below cover what drives each component and why it changes.

Determinants of Aggregate Demand Components

Consumption Expenditure

Consumption ($C$) is spending by households on goods and services, and it's the largest component of aggregate demand in most economies.

Disposable income is the single biggest determinant of consumption. Disposable income equals income minus taxes. When disposable income rises, people have more money available, so they tend to spend more.

The marginal propensity to consume (MPC) measures how much of each additional dollar of disposable income gets spent rather than saved:

$MPC = \frac{\Delta C}{\Delta YD}$

For example, if disposable income rises by $1,000 and consumption rises by $800, the MPC is 0.8. This number matters a lot for the multiplier effect, which you'll encounter later in this unit.

Two other factors shift consumption:

• Future income expectations. If people expect higher income ahead, they spend more now. If they expect job losses or pay cuts, they pull back on spending and save more (this is called the precautionary motive).
• Household wealth. Rising house prices or stock market gains make people feel wealthier and spend more, even if their income hasn't changed. This is the wealth effect. Falling asset prices work in reverse.

Investment Expenditure

Investment ($I$) refers to business spending on capital goods like machinery, equipment, and buildings. It's the most volatile component of AD because it depends heavily on expectations about the future.

Expectations of future profits are the primary driver. When firms are optimistic about demand for their products, they invest more. When uncertainty rises or the outlook turns negative, investment drops sharply.

Interest rates also play a major role:

1. Lower interest rates reduce the cost of borrowing, making more investment projects financially worthwhile.
2. Higher interest rates raise borrowing costs, so firms shelve projects that no longer look profitable.

The marginal efficiency of capital (MEC) is the expected rate of return on an additional unit of capital. A firm will invest as long as the MEC exceeds the interest rate. When the interest rate falls, more projects clear that bar, so investment rises.

Government Spending and Tax Policies

Government spending ($G$) feeds directly into aggregate demand. It includes purchases of goods and services (defense, infrastructure), public investment (education, research), and transfer payments (Social Security, unemployment benefits).

Tax policies affect AD indirectly by changing disposable income. Tax cuts leave households with more to spend, boosting consumption. Tax increases do the opposite.

Together, government spending and taxation form fiscal policy, which is the deliberate use of the government budget to influence aggregate demand:

• Expansionary fiscal policy: Increase $G$, cut taxes, or both. This stimulates AD and is typically used during recessions.
• Contractionary fiscal policy: Decrease $G$, raise taxes, or both. This restrains AD and is typically used to curb inflation during overheating economies.

Net Exports

Net exports ($NX$) equal the value of exports minus the value of imports:

$NX = \text{Exports} - \text{Imports}$

Three main factors determine net exports:

• Domestic income. When domestic income rises, people buy more of everything, including imports. That reduces net exports. When domestic income falls, imports drop and net exports rise.
• Foreign income. When trading partners' incomes rise, they buy more of your country's exports, increasing net exports. The reverse holds when foreign incomes fall.
• Exchange rates. If the domestic currency appreciates (gains value relative to other currencies), exports become more expensive for foreign buyers and imports become cheaper for domestic buyers. Both effects reduce net exports. Depreciation of the domestic currency has the opposite effect, making exports cheaper abroad and imports pricier at home, which increases net exports.