Key points

  • Aggregate demand is the sum of four components: consumption, investment, government spending, and net exports.
  • Consumption can change for a number of reasons, including movements in income, taxes, expectations about future income, and changes in wealth levels.
  • Investment can change in response to its expected profitability, which in turn is shaped by expectations about future economic growth, the creation of new technologies, the price of key inputs, and tax incentives for investment. Investment can also change when interest rates rise or fall.
  • Government spending and taxes are determined by political considerations.
  • Exports and imports change according to relative growth rates and prices between two economies.
  • Disposable income is income after taxes.
  • An inflationary gap exists when equilibrium is at a level of output above potential GDP.
  • A recessionary gap exists when equilibrium is at a level of output below potential GDP.

Aggregate demand in Keynesian analysis

The Keynesian perspective focuses on aggregate demand. The general idea being that firms produce output only if they expect it to sell.
Thus, while the availability of the factors of production determines a nation’s potential gross domestic product, or GDP, the amount of goods and services actually being sold—known as real GDP—depends on how much demand exists across the economy. You can see this concept represented graphically in the diagram below.
The Keynesian AD/AS model
 
Keynes argued that, for reasons we'll explain shortly, aggregate demand is not stable—it can change unexpectedly.
Suppose the economy starts where start text, A, D, 0, end text intersects start text, S, R, A, S, end text at start text, P, 0, end text and start text, Y, p, end text in the diagram above. Because start text, Y, p, end text is potential output, the economy is at full employment. But because aggregate demand is volatile, it can easily fall. Thus, even if we start at start text, Y, p, end text, if aggregate demand falls, we find ourselves in what Keynes termed a recessionary gap. The economy is in equilibrium but with less than full employment, as shown at start text, Y, 1, end text. Keynes believed that the economy would tend to stay in a recessionary gap, with its attendant unemployment, for a significant period of time.
Similarly—though not shown in the figure—if aggregate demand increases, the economy could experience an inflationary gap, where demand is attempting to push the economy past potential output. As a consequence, the economy would experience inflation.
The key policy implication for either situation is that government needs to step in and close the gap, increasing spending during recessions and decreasing spending during booms, to return aggregate demand to match potential output.
Since aggregate demand is total spending, economy-wide, on domestic goods and services, economists also refer to it as total planned expenditure. We can calculate aggregate demand by adding up its four components: consumption expenditure, investment expenditure, government spending, and spending on net exports—exports minus imports.
In this article, we'll examine each component from the Keynesian perspective.

What determines consumption expenditure?

Consumption expenditure is spending by households and individuals on durable goods, nondurable goods, and services. Durable goods are things that last and provide value over time, such as automobiles. Nondurable goods are things like groceries—once you consume them, they are gone. Services are intangible things consumers buy, like healthcare or entertainment.
Keynes identified three factors that affect consumption:
  • Disposable income: For most people, the single most powerful determinant of how much they consume is how much income they have in their take-home pay. This left-over income is also also known as disposable income, which is income after taxes.
  • Expected future income: Consumer expectations about future income also are important in determining consumption. If consumers feel optimistic about the future, they are more likely to spend and increase overall aggregate demand. News of recession and troubles in the economy will make them pull back on consumption.
  • Wealth or credit: When households experience a rise in wealth, they may be willing to consume a higher share of their income and to save less. When the US stock market rose dramatically in the late 1990s, for example, US rates of saving declined, probably in part because people felt that their wealth had increased and there was less need to save. How do people spend beyond their income when they perceive their wealth increasing? The answer is borrowing. On the other side, when the US stock market declined about 40% from March 2008 to March 2009, people felt far greater uncertainty about their economic future, so rates of saving increased while consumption declined.
Finally, Keynes noted that a variety of other factors combine to determine how much people save and spend. If household preferences about saving shift in a way that encourages consumption rather than saving, then aggregate demand will shift out to the right.

What determines investment expenditure?

Spending on new capital goods is called investment expenditure. Investment falls into four categories: producer’s durable equipment and software, new nonresidential structures, changes in inventories, and residential structures. The first three types of investment are conducted by businesses, while the last is conducted by households.
Keynes’s treatment of investment focuses on the key role of expectations about the future in influencing business decisions.
When a business decides to make an investment in physical assets—like plants or equipment—or in intangible assets—like skills or a research and development project—that firm considers both the expected benefits of the investment, like future profits, and the costs of the investment, such as interest rates.
The clearest driver of the benefits of an investment is expectations for future profits. When an economy is expected to grow, businesses perceive a growing market for their products. Their higher degree of business confidence will encourage new investment. For example, in the second half of the 1990s, US investment levels surged from 18% of GDP in 1994 to 21% in 2000. However, when a recession started in 2001, US investment levels quickly sank back to 18% of GDP by 2002.
Interest rates also play a significant role in determining how much investment a firm will make. Just as individuals need to borrow money to purchase homes, businesses need financing when they purchase big ticket items. The cost of investment thus includes the interest rate. Even if the firm has the funds, the interest rate measures the opportunity cost of purchasing business capital. Lower interest rates stimulate investment spending and higher interest rates reduce it.
Many factors can affect the expected profitability on investment. For example, if the price of energy declines, then investments that use energy as an input will yield higher profits. If the government offers special incentives for investment—for example, through the tax code—then investment will look more attractive; conversely, if government removes special investment incentives from the tax code or increases other business taxes, then investment will look less attractive.
Keynes believed that business investment is the most variable of all the components of aggregate demand.

What determines government spending?

The third component of aggregate demand is spending by federal, state, and local governments. Although the United States is usually thought of as a market economy, government still plays a significant role in the economy. Government provides important public services such as national defense, transportation infrastructure, and education.
Keynes recognized that the government budget offered a powerful tool for influencing aggregate demand. Not only could aggregate demand be stimulated by more government spending—or reduced by less government spending—but consumption and investment spending could be influenced by lowering or raising tax rates.
Keynes concluded that during extreme times like deep recessions, only the government had the power and resources to move aggregate demand.

What determines net exports?

Exports are products produced domestically and sold abroad, and imports are products produced abroad but purchased domestically. Since aggregate demand is defined as spending on domestic goods and services, export expenditures add to aggregate demand, while import expenditures subtract from aggregate demand.
Two sets of factors can cause shifts in export and import demand: changes in relative growth rates between countries and changes in relative prices between countries.
The level of demand for a nation’s exports tends to be most heavily affected by what is happening in the economies of the countries that would be purchasing those exports. For example, if major importers of US-made products like Canada, Japan, and Germany have recessions, exports of US products to those countries are likely to decline since quantity of a nation’s imports is directly affected by the amount of income in the domestic economy. More income will bring a higher level of imports.
Exports and imports can also be affected by relative prices of goods in domestic and international markets. If US goods are relatively cheaper compared with goods made in other places—perhaps because a group of US producers has mastered certain productivity breakthroughs—then US exports are likely to rise. If US goods become relatively more expensive—perhaps because a change in the exchange rate between the US dollar and other currencies has pushed up the price of inputs to production in the United States—then exports from US producers are likely to decline.

A quick overview of what drives aggregate demand

We've gone over all the components of aggregate demand and what drives them to change above, but you may find it useful to refer to the table below that summarizes this information.
Determinants of aggregate demand
Reasons for a decrease in aggregate demand   Reasons for an increase in aggregate demand  
Consumption Rise in taxes, fall in income, rise in interest, desire to save more, decrease in wealth, fall in future expected income Consumption Decrease in taxes, increase in income, fall in interest rates, desire to save less, rise in wealth, rise in future expected income
Investment Fall in expected rate of return, rise in interest rates, drop in business confidence Investment Rise in expected rate of return, drop in interest rates, rise in business confidence
Government Reduction in government spending, increase in taxes Government Increase in government spending, decrease in taxes
Net exports Decrease in foreign demand, relative price increase of US goods Net exports Increase in foreign demand, relative price drop of S. goods

Summary

  • Aggregate demand is the sum of four components: consumption, investment, government spending, and net exports.
  • Consumption can change for a number of reasons, including movements in income, taxes, expectations about future income, and changes in wealth levels.
  • Investment can change in response to its expected profitability, which in turn is shaped by expectations about future economic growth, the creation of new technologies, the price of key inputs, and tax incentives for investment. Investment can also change when interest rates rise or fall.
  • Government spending and taxes are determined by political considerations.
  • Exports and imports change according to relative growth rates and prices between two economies.
  • Disposable income is income after taxes.
  • An inflationary gap exists when equilibrium is at a level of output above potential GDP.
  • A recessionary gap exists when equilibrium is at a level of output below potential GDP.