Economics: Aggregate Demand and Investment

Aggregate Demand

• Aggregate Demand = Consumption of goods and services + Investment (Demand for capital goods)
• Investment is the sum of spending made by business firms per unit of time (one year) to build stock of capital
• Capital is the stock of productive assets: machinery, equipment, residential land, buildings, and inventories

Investment

• Investment is a flow concept: measured per unit of time, generally one year
• Investment refers to the addition to the physical stock of capital
• Types of Investment:
  • Induced Investment: caused by the increase in income and decrease in interest rate (I = f(Y, i))
  • Autonomous Investment: caused by exogenous factors such as innovation, invention, expansion plans, and discovery of new markets
• Autonomous investment is largely made by the government in areas such as physical infrastructure, human infrastructure, and public goods

Consumption

• Consumption is based on various factors: income, wealth, interest rate, expected future income, consumer credit, age, and sex
• Income is the primary determinant of consumption and saving
• Consumption Function: C = f(Y) (consumption is a positive function of income)
• Consumption increases with increases in income
• Keynes' "Psychological Law": with an increase in income, consumption does not increase in the same proportion
• Marginal Propensity to Consume (MPC): relationship between marginal income and marginal consumption
• MPC = ΔC/ΔY

Linear Consumption Function

• Applicable to the economy as a whole or at the aggregate level: C = a + bY
• a = positive constant (intercept), denotes autonomous consumption
• b = positive constant, represents the slope of the linear consumption function
• Average Propensity to Consume (APC): APC = C/Y
• APC = a + bY / Y

Saving Function

• Saving function is the counterpart of the consumption function: S = f(Y)
• Saving rises at an increasing rate at the upward movement of national income
• If consumption function is given as C = a + bY, then saving function can be derived as S = Y - C or S = Y - (a + bY) = -a + (1 - b)Y
• 1 - b gives MPS (Marginal Propensity to Save) where b = MPC

Understand the concept of aggregate demand, its components, and investment as a flow concept in economics. Learn how investment adds to the physical stock of capital.