The national income and employment in the short run in an economy depend upon aggregate Demand and aggregate supply. The concept of aggregate demand and aggregate supply was coined by J.M.Keynes a notable English Economist. He showed the mutual relationship between aggregate demand and aggregate supply determines the level of income and employment in a free market Economy, to him the deficiency of aggregate demand relative to aggregate supply of output at full employment of resources given rise to Unemployment.
Aggregate demand is the total expenditure which the consumers, producers and government are willing to make on goods and services in a year. The aggregate demand (AD) Comprises of four components (i) consumption demand (ii) Investment demand (iii) Government expenditure on final good, and services and (iv) Net of exports over imports consumption expenditure is denoted by C, investment expenditure by I and Govt expenditure by G and exports by Xn. The net exports is calculated by the difference between X-M=Xn
Thus Aggregate demand (AD) = C+I+G+Xn
The demand for consumer goods and services depends on the propensity to consume and the level of income of the community. Propensity to consume refers to the general income consumption relationship. It represents functional relationship between two aggregates, i.e. total consumption and total income it indicates the proportion of the aggregate income that shall spent on consumption at various levels of income.
Given the propensity to consume, the amount of consumption demand creases with the increase in income. Thus consumption demand is function of income.
In the figure given below National income is measure along the X axis and consumption demand (C) along the Y axis.
(i) The 45% or (Y=C) line indicates that at all the points on this line whole of the income is consumed and nothing is saved.
(ii) The ABC line (CC) represents consumption function. It is drawn according to the psychological law of consumption. It indicates that income increases consumption also increases, but not as fast as income.
(iii) The ABC line starts from point A and not from origin 0. This is because when income falls to zero, consumption does not fall zero.
(iv) When income is less than consumption (at income levels lengthen OY) the gap is covered by dis-saving
(v) A OY level of in come consumption become equal to Income and there is neither saving no dis-saving.
(vi) When income is more than consumption (at income levels greater than OY) the gap between the 45° line and the ABC line after point B represents positive saving.
However in the short run, propensity to consume, does not change, i.e. consumption function (propensity to consume) remains constant. The propensity to consume, in the short period, depends on consumer’s tastes and preferences, the rate of interest, the level of prices, the income distribution and the population. These factors ore or less remain constant during short period. With the increase the above factors, the whole consumption function curve will shift upward.
Investment demand is another component of Aggregate demand. Investment means buying of new physical capital assets such as machinery, tools, equipment, buildings. Expenditure on the stock of consumer goods and ratio materials is also considered as investment. The investment demand depends on two factors.
(i) Marginal efficiency of capital
(ii) The rate of interest.
The marginal efficiency of capital (MEC) refers to the expected profitability of a capital asset. It may be defined as the highest rate of return over cost expected from the marginal or additional unit of a capital asset. Between the two factors rate of interest is comparatively sticky and does not frequently charge in the short run. Given the rate of interest changes in investment demand in the short run occur due to the changes in marginal efficiency of capital. Thus investment demand depends on the profitability from the employment of additional capital unit.
The Government expenditure on final goods and services constitutes another component of aggregate demand. The Govt purchases goods and services for two purposes. Firstly the Govt spends on the infrastructure like construction of highways, flood control project, education, communication etc. This is the developmental expenditure of the Govt, secondly the Govt, spend on police and public administration, defence and other social services.
The first type of Govt, expenditure resembles private investment expenditure and the second type resembles private consumption expenditure. There expenditures are not productive as it does not help in producing further goods. Govt, also make expenditure on social security measures like old age pension sickness benefits, subsidies etc. This type of expenditure is call cash transfer or transfer payment.
It is important to note the Govt; expenditure is independent of national income an autonomous in nature like private investment expenditure.
Export means shipping goods to foreign countries for it represents foreign demand for country’s product. The export revenue i.e. the amount of expenditure on the goods of the exporting country by the foreign people adds to the total expenditure of aggregate demand in the exporting country’s economy.
Thus exports are like investment expenditure as both create income and demand for good. As against the export imports of a country generate demand for foreign goods. Therefore imports constitute leakage from the domestic flow of income and reduce domestic aggregate demand. Thus net exports over imports (X – M) of a country are a component of aggregate demand.