ECON3130 - Determinants of Aggregate Demand: Consumption and Investment

Consumption is the largest element of aggregate demand.
It measures the total planned level of demand in an economy by households for final goods and services.
Aggregate Demand (AD) is defined as: $AD = C + I + G + X - M$ , where:
- C = Consumption
- I = Investment
- G = Government Spending
- X = Exports
- M = Imports
World Bank data indicates the structure of demand, including final consumption expenditure, general government final consumption expenditure, households and NPISHs final consumption expenditure, and gross capital formation as percentages of GDP for various countries in 2010 and 2023.

The Keynesian consumption function is expressed as: $C = a + bY_d$ , where:
- $a$ = Autonomous consumption (consumption independent of income).
- $b$ = Marginal propensity to consume (MPC).
- $Y_d$ = Disposable income.
MPC is the proportion of an increase in disposable income that is spent on consumption.
A graph illustrates the consumption function, plotting consumption (C) against income (Y), showing autonomous consumption and the relationship $C = a + bY_d$ .

The marginal propensity to consume (MPC) depends on:

Interest rates: Higher interest rates may discourage consumption.
Expectations of future price increases: Anticipation of inflation may increase current consumption.
Expectations of the future state of the economy: Optimistic outlook may boost consumption.
Income levels: Higher income levels may influence MPC.
The availability and quality of domestic goods compared to foreign goods: Preference for domestic goods may increase MPC.

The multiplier effect explains how an increase in planned injections into the economy increases national income by more than the initial amount of injection.
The multiplier (M) is calculated as: $M = \\frac{1}{1 - mpc}$ , where MPC represents the marginal propensity to consume.
MPC measures the amount of extra income that is spent on domestic goods and services.
Example: if $mpc = 0.9$ , then the multiplier $M = \\frac{1}{1 - 0.9} = 10$ .

Individuals dis-save (borrow or use savings) early and late in life and save during their prime working years.
A graph illustrates consumption, current income, and age, showing periods of dis-saving and saving over the life cycle.

Developed The Permanent Income Theory (1957).
What matters to consumers when spending is not their present income but rather their ‘permanent income.’
Changes in disposable income that are not expected to last will not have much effect on current spending.

Investment is an injection into the economy.
Investment occurs when firms decide to allocate resources into projects that will generate future returns.
Businesses invest for the future, so expectations about costs and demand are important influences.
Expectations can change quickly, making investment a volatile element of aggregate demand.
World Bank data indicates the structure of demand, including final consumption expenditure, general government final consumption expenditure, households and NPISHs final consumption expenditure, and gross capital formation as percentages of GDP for various countries in 2010 and 2023.
World Bank measures for business regulations are:
- Ease of Doing Business Rank
- Starting a Business
- Dealing with Construction Permits
- Getting Electricity
- Registering Property

Fixed capital: Purchase of assets expected to be used for a long period (e.g., transport, factories, production equipment).
Working capital: Short-term assets used up in the production process (e.g., stocks and materials).

Gross investment: Total investment in an economy in a period.
Depreciation Investment: Investment undertaken to replace worn-out equipment or machinery; maintains the level and quality of the capital stock.
Net investment: New investment that increases the capital stock in the economy.
Relationship: $Gross \ investment = Net \ investment + Depreciation \ investment$

The marginal efficiency of capital (MEC) shows the rate of return on an additional investment project.
This return can be compared with the cost of borrowing to decide whether to invest in a project.
Decision rule:
- If MEC > r (cost of borrowing) → project should proceed.
- If MEC < r → project should not proceed.
A profit-maximizing firm should invest up to the point at which $MEC = interest \ rate$ .

A change in interest rates affects the cost of borrowing and leads to a movement along the MEC curve.
- Higher interest rates reduce the number of projects that earn enough to cover costs, so investment falls.
A change in the expected future returns on a project leads to a shift in the MEC curve.
- Expected returns have changed for each level of investment.

Cost–benefit analysis is a technique used mainly by governments when assessing an investment project.
It tries to quantify the external costs and external benefits involved in any project.
Governments consider the full social impacts of any project, not only private costs and benefits.
Examples: infrastructure, health services, educational services, etc.

Consumption is an important element of aggregate demand.
The level of consumption in an economy may be influenced by a range of factors, including current income, estimates of permanent income, interest rates, expectations of the price level, the availability of credit, and the age distribution.
An increase in consumption increases the aggregate demand.
Investment depends in part on expectations of the future and can be volatile.
Changes in investment lead to changes in aggregate demand.
An increase in interest rates is likely to decrease the level of investment and therefore the level of aggregate demand.
The MEC shows the expected return on investment projects.
A cost–benefit analysis uses social costs and benefits rather than private costs and benefits when assessing an investment.