The Components of Aggregate Demand
Learning Objectives
By the end of this section, you will be able to:
- Explain real GDP, recessionary gaps, and inflationary gaps
- Recognize the Keynesian AD/AS model
- Identify the determining factors of both consumption expenditure and investment expenditure
- Analyze the factors that determine government spending and net exports
The Keynesian perspective focuses on aggregate demand. The idea is simple: firms produce output only if they expect it to sell. Thus, while the availability of the factors of production determines a nation’s potential GDP, the amount of goods and services that actually sell, known as real GDP, depends on how much demand exists across the economy.
Keynes argued that, for reasons we explain shortly, aggregate demand (AD) is not stable—that it can change unexpectedly. Suppose the economy starts where AD is sufficient to induce firms to produce at potential output–that is, at full employment. Because AD is volatile, it can easily fall. Thus, even if we start at full employment, if AD falls, then we find ourselves in what Keynes termed a recessionary gap. The economy is in equilibrium but with less than full employment. Keynes believed that the economy would tend to stay in a recessionary gap, with its attendant unemployment, for a significant period of time.
In the same way if AD increases, the economy could experience an inflationary gap, where demand is attempting to push the economy past potential output. Consequently, the economy experiences inflation.
The key policy implication for either situation is that government needs to step in and close the gap, increasing spending during recessions and decreasing spending during periods of high inflation to return aggregate demand to match potential output.
Recall from The Aggregate Demand-Aggregate Supply Model that aggregate demand is total spending, economy-wide, on domestic goods and services. (Aggregate demand (AD) is actually what economists call total planned expenditure. You will learn more about this later in the chapter.) You may also remember that aggregate demand is the sum of four components: consumption expenditure, investment expenditure, government spending, and spending on net exports (exports minus imports). In the following sections, we will examine each component through the Keynesian perspective.
What Determines Consumption Expenditure?
Consumption expenditure is spending by households and individuals on durable goods, nondurable goods, and services. Durable goods are items that last and provide value over time, such as automobiles. Nondurable goods are things like groceries—once you consume them, they are gone. Recall from The Macroeconomic Perspective that services are intangible things consumers buy, like healthcare or entertainment.
Keynes identified three factors that affect consumption:
- Disposable income: For most people, the single most powerful determinant of how much they consume is how much income they have in their take-home pay, also known as disposable income, which is income after taxes.
- Expected future income: Consumer expectations about future income also are important in determining consumption. If consumers feel optimistic about the future, they are more likely to spend and increase overall aggregate demand. News of recession and troubles in the economy will make them pull back on consumption.
- Wealth or credit: When households experience a rise in wealth, they may be willing to consume a higher share of their income and to save less. When the U.S. stock market rose dramatically in the late 1990s, for example, U.S. savings rates declined, probably in part because people felt that their wealth had increased and there was less need to save. How do people spend beyond their income, when they perceive their wealth increasing? The answer is borrowing. On the other side, when the U.S. stock market declined about 40% from March 2008 to March 2009, people felt far greater uncertainty about their economic future, so savings rates increased while consumption declined.
Finally, Keynes noted that a variety of other factors combine to determine how much people save and spend. If household preferences about saving shift in a way that encourages consumption rather than saving, then AD will increase.
Visit this website for more information about how the recession affected various groups of people.
What Determines Investment Expenditure?
We call spending on new capital goods investment expenditure. Investment falls into four categories: producer’s durable equipment and software, nonresidential structures (such as factories, offices, and retail locations), changes in inventories, and residential structures (such as single-family homes, townhouses, and apartment buildings).
Keynes’s treatment of investment focuses on the key role of expectations about the future in influencing business decisions. When a business decides to make an investment in physical assets, like plants or equipment, or in intangible assets, like skills or a research and development project, that firm considers both the expected investment benefits (future profit expectations) and the investment costs (interest rates).
- Expectations of future profits: The clearest driver of investment benefits is expectations for future profits. When we expect an economy to grow, businesses perceive a growing market for their products. Their higher degree of business confidence will encourage new investment. For example, in the second half of the 1990s, U.S. investment levels surged from 18% of GDP in 1994 to 21% in 2000. However, when a recession started in 2001, U.S. investment levels quickly sank back to 18% of GDP by 2002.
- Interest rates also play a role in determining how much investment a firm will make. Just as individuals need to borrow money to purchase homes, so businesses often finance their purchases of big ticket items. The cost of investment thus includes the interest rate. Even if the firm has the funds, the interest rate measures the opportunity cost of purchasing business capital. Lower interest rates can stimulate investment spending and higher interest rates can reduce it.
Many factors can affect the expected profitability on investment. For example, if energy prices decline, then investments that use energy as an input will yield higher profits. If government offers special incentives for investment (for example, through the tax code), then investment will look more attractive; conversely, if government removes special investment incentives from the tax code, or increases other business taxes, then investment will look less attractive. As Keynes noted, business investment is the most variable of all the components of aggregate demand.
What Determines Government Spending?
The third component of aggregate demand is federal, state, and local government spending. Although we usually view the United States as a market economy, government still plays a significant role in the economy. As we discuss in Environmental Protection and Negative Externalities and Positive Externalities and Public Goods, government provides important public services such as national defense, transportation infrastructure, and education.
Keynes recognized that the government budget offered a powerful tool for influencing aggregate demand. Not only could more government spending stimulate AD (or less government spending reduce it), but lowering or raising tax rates could influence consumption and investment spending as well. Keynes concluded that during extreme times like deep recessions, only the government had the power and resources to move aggregate demand.
What Determines Net Exports?
Recall that exports are domestically produced products that sell abroad while imports are foreign produced products that consumers purchase domestically. Since we define aggregate demand as spending on domestic goods and services, export expenditures add to AD, while import expenditures subtract from AD.
Two sets of factors can cause shifts in export and import demand: changes in relative growth rates between countries and changes in relative prices between countries. What is happening in the countries’ economies that would be purchasing those exports heavily affects the level of demand for a nation’s exports. For example, if major importers of American-made products like Canada, Japan, and Germany have recessions, exports of U.S. products to those countries are likely to decline. Conversely, the amount of income in the domestic economy directly affects the quantity of a nation’s imports: more income will bring a higher level of imports.
Relative prices of goods in domestic and international markets can also affect exports and imports. If U.S. goods are relatively cheaper compared with goods made in other places, perhaps because a group of U.S. producers has mastered certain productivity breakthroughs, then U.S. exports are likely to rise. If U.S. goods become relatively more expensive, perhaps because a change in the exchange rate between the U.S. dollar and other currencies has pushed up the price of inputs to production in the United States, then exports from U.S. producers are likely to decline.
Summary
Aggregate demand is the sum of four components: consumption, investment, government spending, and net exports. Consumption will change for a number of reasons, including movements in income, taxes, expectations about future income, and changes in wealth levels. Investment will change in response to its expected profitability, which in turn is shaped by expectations about future economic growth, the creation of new technologies, the price of key inputs, and tax incentives for investment. Investment will also change when interest rates rise or fall. Political considerations determine government spending and taxes. Exports and imports change according to relative growth rates and prices between two economies.
Table 1 summarizes the reasons we have explained for changes in aggregate demand.
| Reasons for a Decrease in Aggregate Demand | Reasons for an Increase in Aggregate Demand |
|---|---|
Consumption
|
Consumption
|
Investment
|
Investment
|
Government
|
Government
|
Net Exports
|
Net Exports
|
References
Mahapatra, Lisa. “US Exports To China Have Grown 294% Over The Past Decade.” International Business Times. Last modified July 09, 2013. http://www.ibtimes.com/us-exports-china-have-grown-294-over-past-decade-1338693.
The Conference Board, Inc. “Global Economic Outlook 2014, November 2013.” http://www.conference-board.org/data/globaloutlook.cfm.
Thomas, G. Scott. “Recession claimed 170,000 small businesses in two years.” The Business Journals. Last modified July 24, 2012. http://www.bizjournals.com/bizjournals/on-numbers/scott-thomas/2012/07/recession-claimed-170000-small.html.
United States Department of Labor: Bureau of Labor Statistics. “Top Picks.” http://data.bls.gov/cgi-bin/surveymost?bls.
Glossary
- disposable income
- income after taxes
- inflationary gap
- equilibrium at a level of output above potential GDP
- real GDP
- the amount of goods and services actually sold in a nation
- recessionary gap
- equilibrium at a level of output below potential GDP
the maximum quantity that an economy can produce given full employment of its existing levels of labor, physical capital, technology, and institutions
GDP adjusted for changes in prices over time
equilibrium at a level of output below potential GDP
equilibrium at a level of output above potential GDP
the amount of total spending on domestic goods and services in an economy
income after taxes
products (goods and services) made domestically and sold abroad
products (goods and services) made abroad and then sold domestically