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Macroeconomics: components of aggregate demand

  • Consumption: purchases of durable and non-durable goods and services by domestic households
    • In the US, consumption is the largest component of aggregate demand, equaling about 70% of the nation's GDP as of 2019.
    • Determinant of consumption:
      • The level of income  determines the level of consumption. If the income level increases, consumption rises.
      • Average propensity to consume (APC)  and save (APS): at low (high) income levels the APC is high (low). This is the proportion of national income that goes to consumption. At low (high) income levels the APS is low (high).

      • Marginal propensity to consume (MPC): the change in consumption that results from a change in income.

      • Marginal propensity to save (MPS): the change in savings that results from a change in income.

      • MPS + MPC =1 in a closed economy.
      •  Wealth impacts the level of consumption. Household wealth includes assets minus liabilities.  Assets include real estate, stocks, bonds, and savings. When asset prices rise (fall), households feel richer (poorer), and tend to consumer more (less).
      • Interest rate influences the level of consumption. At higher (lower) interest rate households prefer to save (consume) and consume (save) less.
  • Investment: purchase of capital goods by firms and the purchase of a newly built houses by households. 
    • In the US, investment made up approximately 18% of GDP in 2019.
    • Determinants of investment:
      • Interest rates: high (low) interest rates, it is more (less) costly for firms to acquire new capital. There is an inverse relationship between the interest rate of a nation and the quantity of funds demanded for investment. Whereas there is a direct relationship between the (real) interest rate and the supply of funds for investment.


      • Technology: new technologies lead to an rise in demand for funds for investment. 
      • government regulation and taxes:  lower (higher) regulations by the government increase (decrease) the demand for investment.
  • Government spending: expenditure of the government on goods and services. It represented about 17% of the US GDP in 2019.
    • Determinant of government spending:
      • Fiscal policy: When the economy is growing and producing at or near full employment government spending can decrease. If the economy is contracting, government spending tends to increase.
  • Net Export: total revenue earned by exports minus total spending on imports. Net export represented -5% of the 2019 US GDP.
    •  Determinants of Net Export:
      • Foreign consumer's income: If the incomes abroad increase, exports should increase.
      • Exchange rates: If a country's currency becomes stronger (weaker) relative to its trading partners' currencies, then its exports fall (rise), lowering (increasing) net export.
      • Protectionism: the use of government policies to reduce the level of imported goods into its economy (tariffs, quotas, subsidies to domestic producers). Most economists believe that these policies reduce the overall benefit of trading.
Reference: Welker, Jason. AP Maroeconomics Crash Course. Research & Education Association (2014). p 109-118.

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