Ch205 - CHAPTER 5 ITS AGGREGATE DEMAND AND COMPONENTS We...

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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”. 1 This relationship between consumption and income is called the consumption function. The consumption function may be represented by the following equation. A GGREGATE D EMAND AND ITS C OMPONENTS C HAPTER 5 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 1 This relationship between consumption and income holds good for the individual, the household, as well as for the economy as a whole. In the context of this chapter, consumption and income shall be understood as referring to aggregate consumption and income.
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A GGREGATE D EMAND AND ITS C OMPONENTS 53 C = C + bY C > 0, 0 < b < I. Where, C = Consumption C = Autonomous Consumption b = Marginal Propensity to Consume Y = Level of income The intercept C represents autonomous consumption, that is, the amount of consumption expenditure when income is zero. 2 C is assumed to be positive, that is, there is consumption even in the absence of any income. Hence, it is not possible to think of a situation where there is no consumption at all. The slope of the consumption function is ‘b’. It measures the rate of change in consumption per unit change in income and is also known as the Marginal Propensity to Consume (MPC). 3 For example, if b is 0.6, then a rupee change in income causes a 0.60 rupee change in consumption. If b is 0.45, then a rupee change in income will cause a 0.45 rupee change in consumption. By assumption, the MPC is positive, and its value ranges between 0 and 1.
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