© 1999-2003
Douglas A. Ruby
Revised: 01/15/2003

National Income Accounting

Aggregate Expenditure

Consumption Decisions

Investment Decisions

Net Exports and Trade

Demand-Side Equilibrium

Price Level Determination

Macroeconomic Principles

Macroeconomic Theory
The Components of Aggregate Demand

The concept of aggregate demand is used to understand and measure the ability, and willingness, of individuals and institutions to purchase goods and services. 

Hong Kong: Embracing trade

Say's law stated that "Supply creates its own Demand" in which the income earned producing a certain quantity of goods and services should be sufficient to purchase and identical quantity of those same products. However in a complex economy with sticky prices and wages, financial sectors in various stages of development, political institutions that fail to promote certainty and optimism, and strong international linkages and dependencies -- this law may not always hold. The ability to spend on the output of an economy may not be identical to the ability to produce that output.

Aggregate demand is a measure the ability to spend or a level of expenditure used to command varying quantities of goods and services at different price levels. This concept is a measure of purchasing power such that when prices increase with a given level of nominal income, fewer goods or services can be purchased.

In understanding the behavior of aggregate demand we must take a close look at its individual components:

  AD: Nominal Income = PtYRt = (Ct + It + Gt + NXt )

Aggregate Demand
For a given level of  nominal expenditure, an inverse relationship exists between  the price level 'P' and  Real Income 'YR'. Aggregate demand represents this inverse relationship between the price level and a given level of purchasing power in an economy.


AD = {YRt,Pt ε R2 | YRt = YtNominal/Pt}

Any factor that affects consumption, investment, government, or export-import decisions will translate in to a change in nominal expenditure and, at an existing price level, a change in purchasing power. These factors may include changes in interest rates, exchange rates, wealth, taxes, public spending, expectations, or monetary policy targets.

Consumption Expenditure
Of the four components of aggregate demand, consumption expenditure C is the largest contributing to between 60% and 70% of total expenditure. For this reason, we often start our analysis with this particular component. This category of expenditure includes private spending on durable goods (automobiles, electronic goods, appliances, ... ), non-durable goods (food, clothing, books and magazines,...), and services (housing, health-care, education, entertainment,...).

Special attention must be given to the service component of consumption expenditure for several reasons. First, services represent the largest component representing at least 50 percent of this type of spending. Second, services include housing services measured directly by rents being paid from tenant to landlord, in the case of rental housing, or indirectly as imputed rent that an individual would pay to himself in the case of owner occupied housing. In the latter case the homeowner acts as both tenant and landlord with no actual payment changing hands but imputed expenditure being included in the services category to reflect the value of the housing services received from the owner-occupied home. Third, services, unlike durable and some non-durable goods, are difficult to accumulate as inventory. Thus any changes in the demand for services (due to changing preferences or the general level of economic activity) must be immediately matched with changes in production. This is not always an easy task in any economy.

Consumption expenditure decisions are strongly influenced by household disposable (after-tax) income, household wealth, savings needs and plans, confidence in the future direction of the economy, and interest rates (in the case of durable-goods purchases).

Investment Expenditure
Investment expenditure I represents a smaller share of the total but tends to be the most volatile component leading to the cyclical behavior of aggregate demand. This category of expenditure includes fixed nonresidential investment (factories, machines, transport equipment), fixed residential investment (new houses and apartments), and business inventories. Often the volatility in investment results from fluctuation in inventory levels due to changing expectation about business conditions.

Fixed residential and nonresidential investment refers to the creation of income-producing assets. Assets that will generate net-benefits (benefits-costs from housing services) in the case of owner-occupied housing or generate profits as part of the production process. These net-benefits and profits depend on the expected revenue or gross benefits generated by the asset as well as the costs of acquiring, maintaining and replacing these assets.

Demand for the production of the asset will directly affect the revenue generated. Strong demand based on preferences, optimism, purchasing power, or demographics will lead to the desire for more investment expenditure.

Acquisition costs include both the purchase price of the asset and the borrowing costs involved both which are highly sensitive to changes in interest rates. Higher interest rates lead to higher borrowing costs and thus lower net-benefits or profits such that the level of aggregate investment expenditure may be reduced. Maintenance and replacement costs depend on the useful life of an asset and its rate of depreciation. Assets that wear out very quickly or become obsolete in a short period of time have higher costs with the same effect as rising interest rates. Because of the sensitivity of investment decisions to changing interest rates, this category of expenditure is easily affected by monetary policies and activity in the financial sector of an economy.

Government Expenditure
Government expenditure G is a reflection of the fiscal needs and policies of the public sector in a given economy. This type of expenditure might be in reaction to the demand for public goods and services by private households and businesses through voting or other types of political activity. In addition, government expenditure could be used as a deliberate policy tool to increase nominal incomes in the hope of stimulating aggregate demand.

Net Export Expenditure
Finally, Net export expenditure NX reflects the international linkages based directly on service and merchandise flows across borders in addition indirectly reflecting capital flows into and out of a particular country. Merchandise flows are sensitive to domestic income levels and preferences for foreign-made goods. In addition these flows are influenced by exchange rates which determine the domestic price of goods and services produced abroad. Capital flows depend on interest rate (yield) differentials among nations as well as exchange rates which affect the domestic price of a foreign asset both at the time of purchase of that asset and at the time of sale.

As we will see in the following sections, specific spending components may be defined by  broad functional relationships:

    Ct = f{income (Yd), wealth (W), taxes (T) , interest rates (r) , and prices (Pt)}

    It = f{interest rates (r), capital productivity and longevity, and income(Yt)}

    Gt = f{fiscal policies, budgetary needs and borrowing constraints}

    NXt = Exports - Imports

= f{exchange rates(e.r.), interest rates (rdomestic,rforeign),
domestic and foreign income (Yd,Yf)}

In addition interest rates and exchange rates are affected by activity in the financial sector of the economy. This activity may include changes in monetary policy as administered by central banking authorities and changes in expectations of future economic activity, inflation, and credit risk.

Concepts for Review:
  • Aggregate Demand
  • Business Inventories
  • Consumption Expenditure
  • Durable Goods
  • Exports
  • Fixed Nonresidential Investment
  • Fixed Residential Investment
  • Government Expenditure
  • Imports
  • Investment Expenditure
  • Net-Exports
  • Non-Durable Goods
  • Say's Law
  • Services