Aggregate demand is a macroeconomic term that measures the total demand in the economy at a certain time over a set period. In fact, Gross Domestic Product (GDP) is very similar.
It is the total (final) expenditure of all the units of the economy, i.e., households, firms, government, and the rest of the world.
Aggregate demand is made up of four components - consumption, investment, government spending, and net exports (exports - imports).
AD = C + I + G + (X - M)
Household consumption expenditure (C)
- It comprises a household's expenditure on the consumption of goods and services.
- These goods can be durable, semi-durable, or non-durable.
- Consumption of households depends upon their disposable income and MPC.
Investment expenditure (I)
- It refers to the expenditure incurred by firms on the purchase of capital goods like machines, plants, equipment, etc., to increase the production capacity.
- Investment decision depends upon the relative values of MEI (Rate of return/Marginal efficiency of investment) and rate of interest.
Government expenditure (G)
- It refers to expenditure incurred by the government on the purchase of consumer goods and capital goods to satisfy the collective wants of the society. Example: public parks, public hospitals, roads, etc.
- Government expenditure depends upon the priorities of the government.
Net exports (X - M)
- It is the difference between exports and imports.
- It reflects the net demand for a domestic product by the rest of the world.
- Net exports depend upon many things like foreign trade policy, foreign exchange rate, comparative prices, quality, etc.