National Income Determination II
Aggregate demand - theories of consumption,
investment, and government spending.
What factors determine aggregate consumption?
Like we saw last week, the most important feature of the Aggregate
Demand/Aggregate Supply Model is that it brings together different
markets to show how the economy functions as a single integrated
The model uses the economists' most popular tools: demand and supply
variations in accordance with individual decisions, or groups of
individual decisions. In doing so, it clarifies the nature of the
linkages that characterize a modern economy: a capitalist economy,
Today we will deal with aggregate demand only.
AGGREGATE DEMAND is the amount people wish to spend on the output
of the domestic economy.
There are two crucial concepts involved in the above definition:
1) aggregate demand is what people WISH to spend: thus, it is their
desired or planned level of SPENDING. This, of course, may differ
from the actual amount of NATIONAL EXPENDITURE.
So, if aggregate demand exceeds actual national expenditure, then
SOME WOULD-BE PURCHASES REMAIN UNSATISFIED. Conversely, aggregate
demand could be less than actual national expenditure, in which
case SOME FIRMS WOULD END UP WITH UNSOLD GOODS ON THEIR HANDS,
stocks will accumulate.
2) aggregate demand is the demand for output produced in the domestic
economy on the part of DOMESTIC and FOREIGN RESIDENTS. That is,
it includes exports and excludes imports. Thus, aggregate demand
IS NOT the total amount DOMESTIC residents want to spend, as
this latter amount includes imports which are part of the
national output of foreign countries.
The standard classification of the major components of aggregate
demand is as follows:
Components of aggregate demand Symbol for real value
of the variable
government expenditure G
aggregate demand AD = C + I + G + (H-M)
From the above, if we wanted to know what is the total demand
for domestic and imported goods and services, we have to add up
C, I and G. This new aggregate is known as DOMESTIC ABSORPTION.
Thus, if domestic absorption is large than gross domestic
product, some sectors of the economy are spending above their
domestic income. The latter can be expressed as follows:
C + I + G > GDP
If C + I + G < GDP
foreigners must be persuaded to buy the excess of output, etc.
THE GOODS MARKET
The goods market is concerned with the determination of the
components of aggregate demand.
Consumption is the largest component. Because we are setting our
model in a market economy, consumption will be related to the
"ability to pay", and not to the "basic needs" of individuals,
families or social groups. Thus, consumption will depende on
prices of consumer goods
( Note about wealth. The distinction between income and wealth is
as follows: a person who has a regular salary has an income. If
the same person has savings of any kind, then that person has
wealth also. Therefore, someone with high income but not wealth
can be rich, and so can someone with high wealth but no income,
like a rentier. But each is rich in a different way from the
other. Now, income is not protected against inflation, because
it changes only after long periods -a year, or so-. Wealth is
protected against inflation, because its value changes with
If we introduce the notion of inflation now, consumption will
real income, and
Real means prices recalculated in accordance with levels of
inflation in order to derive the real value of money at any
point in time.
The general idea we are dealing with here is that consumption will
depend on income most of the time, because part of this income
will be saved to be transformed in wealth. This notional structure
is known in economics as the CONSUMPTION FUNCTION.
This conceptualization is historical: when Keynes publicized his
ideas on the determinants of consumption, he concentrated strongly
on the causal effect of income. Keynes' view was that "as a rule,
the amount of aggregate consumption mainly depends on the amount
of aggregate income...The fundamental psychological law...is that men
are disposed, as a rule and on the average, to increase their
consumption as their income increases, but not as much as the
increase in their income" (in Keynes, "The general theory of
employment, interest and money", Macmillan, 1936, p. 96).
Because of the above, then, the consumption function will depend
real national output (measured as income)
nominal money supply ( the number of national currency units held
as cash and bank deposits)
price level of all goods and services, and
real money balances, which will be nominal money suppply divided
by price level.
THE MONEY MARKET
In very crude terms, the money market is defined by the interaction
of suppply of money (savings) and the demand for money (investment).
Of course, levels of savings will be very closely related to levels
of income, and the latter, to levels of national income. Also,
demand for money will be related to interest rates and, again, to
levels of consumption ( demand for goods and services, that is ).
The rate of interest is regarded as the "price" of money in the
sense that the opportunity cost of holding money is the rate of
interest foregone by not holding some kind of savings.
Now, we are in a position to describe a demand for money function:
the quantity of real money balances demanded will be a function of
real national income/output, and
rate of interest
We must be aware here that demand for money will be an outcome of
economic activities, while supply of money will be exogeneous to
the economic activities if economic policies intervene with
variations in intereste rate, selling or buying bonds, or
simply printint money.
Naturally, an increase in the supply of real money balances
reduces the rate of interest while a decrease in the supply
of real money balances has the opposite effect and increases
the rate of interest.
By the same token, an increase in the rate of interest decreases
the demand for money but increases the suppply of money. On the
other hand, foreign speculative investments, if the rate of interest
increases, can push demand for money up, etc.
The money market will be at equilibrium when supply and demand
WHAT ARE THE LINKS BETWEEN THE MONEY MARKET AND THE GOODS MARKET
The first link is a DIRECT relationship between the quantity of
real balances and the level of consumption. The larger the
quantity of real money balances the greater is consumption,
because consumers have more wealth to spend.
The second link is INDIRECT. An increase in the quantity of real
money balances lowers the interest rate and so increases investment
and consumption. It is an indirect link between real money balances
and aggregate demand because it comes about via changes in the rate
THUS, IN ORDER TO ANALYSE THE DETERMINANTS OF AGGREGATE DEMAND WE
NEED TO CONSIDER BOTH THE GOODS MARKET AND THE MONEY MARKET AND
THE INTERCONNECTIONS BETWEEN THEM.
THE LABOUR MARKET
Basic economic theory rightly assumes that demand for labour is
a DERIVED demand. That is, demand for labour will be a function
of demand for goods and services in the general economy and of
levels of technology (capital-intensive or labour-intensive).
Thus, the main link between the labour market and the goods market
is levels of income. And the main link between levels of employment
and the goods market is levels of technology.
Because of the above, economic objectives related to full
employment have to be achieved through fiscal policies. There are
two extreme types of fiscal policy: contractionary and expansionary.
EXPANSIONARY FISCAL POLICY:
1.- Increased demand and output
1.1 Increased employment while technologies
1.2 Higher wage/cost pressures if levels
of unemployment are too low.
1.3 Rising prices because of demand-pull inflation.
1.4 Higher imports of capital goods and
intermediate goods. If exports do not increase
to cover for higher imports, then
1.5 Foreign trade deficit.
CONTRACTIONARY FISCAL POLICY:
1.- Decreased demand and output
1.1 Reduced employment
1.2 Less wage/cost pressures. The share of gross
profits in value created could increases
leading to extreme cases of maximization of
profits. Income polarization will grow.
1.3 Stable prices make the economy appear as
1.4 Lower imports if less consumption of capital
and intermediate goods, but more imports
could occur if extreme levels of profits
push luxury consumption up.
1.5 Tendency to trade surplus.
The above listing illustrates the relationships between changes in
policy instruments and the subsequent effects on the target variables.
Changes in fiscal policy can be either expansionary (increased deficit
spending) or contractionary (reduced deficit spending).
Contradictory outcomes are described above:
Under an expansionary fiscal policy, output and employment may benefit
but at the expense of inflation and foreign trade. Similarly, a
contractionary policy may have good and bad outcomes such as stable
prices and trade surplus but at the expense of output and employment.
The problem of achieving multiple and conflicting objectives with the
available policy instruments in a free-market economy is still
unsolved. Those who trust the market (monetarists) suggest that
the government must leave the market forces to their own, those
who distrust the market (keynesians) suggest that "fine tuned"
management of demand will do the trick. By and large, the capitalist
system proves both of them wrong, and the free-market system, with
government intervention or not, keeps leading to higher levels
of unemployment, wider polarization between rich and poor, and
to "fracture" industrialized societies between an affluent half
and a dispossessed half. The later not only dispossessed of a decent
income, but also education, health, and housing.