We have defined aggregate demand as the total demand for goods and services in the economy. In this chapter we will look at the components of aggregate demand, and what determines the magnitudes of these components. Our discussion in this connection will be based upon a simple model of Keynesian macroeconomics.

The components of aggregate demand include goods and services demanded for private consumption (C), for investment (I), for government expenditure (G) and for net exports (X-M). Aggregate demand (AD) is therefore given by

AD = C + I + G + (X-M)

We may now focus on the determinants of the individual components of aggregate demand.

Consumption demand and consumption function

Consumption demand in microeconomics is defined as the value of commodities and of services that households are able and willing to buy at a particular time. This demand is influenced by many variables such as price of the goods or services, income, wealth, expected income, tastes and preferences of individuals and so on. Keynes formulated his fundamental Psychological Law of Consumption to lay down a behavioural rule to the process of consumption activity.

Keynes proposed that consumption demand increases with the level of income. His ‘fundamental psychological law’, holds, that “men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income”. This relationship between consumption and income is called the consumption function.

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Aggregate Demand and its components.pdf