Aggregate demand and its components

The essentials

Aggregate demand (AD) is the total planned expenditure on final goods and services in an economy during a period. In a two-sector economy AD = C + I; in a full economy AD = C + I + G + (X − M).

Consumption (C) depends mainly on income. The consumption function is C = c̄ + bY. Here c̄ is autonomous consumption, spending that takes place even at zero income (financed from past savings or borrowing), and b is the marginal propensity to consume (MPC). Saving is the part of income not consumed: S = Y − C = −c̄ + (1 − b)Y.

Investment (I) is planned addition to the stock of capital. In the simple model it is taken as autonomous, not depending on income; it depends on things like the rate of interest and expected returns.

Key points

• APC = C ÷ Y; APS = S ÷ Y; APC + APS = 1.
• MPC = ΔC ÷ ΔY; MPS = ΔS ÷ ΔY; MPC + MPS = 1.
• MPC lies between 0 and 1; APC can be greater than 1 at low incomes (dissaving).
• At the break-even point, C = Y and saving is zero.
• Ex ante means planned; ex post means actual or realised.

Exam tips

Check that propensities add to 1 before using them. In tables, compute MPC from changes, not from levels.

Common mistakes

• Saying MPC can exceed 1; in the textbook model it cannot.
• Using APC in the multiplier formula instead of MPC.