Economics: Aggregate Demand and Investment

Study Notes

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 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 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

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