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Assad Sheerah
00701510

(Business & Humanities)

24/03/2011

Introduction

This essay covers Aggregate Demand and its relationship with economic growth, unemployment, inflation, and balance of payment. The paper begins with a detailed account of aggregate demand then progresses to illustrate its relationship with some economic objectives. In brief, Economic Growth is the positive change in output level for country over a specific period whilst Unemployment reflects a condition in an economy where individuals who are actively looking for jobs remain unemployed. The economic term Inflation describes a perpetual rise in prices of goods and services in an economy over a period of time. Finally, Balance of Payment which is an account of monetary transactions between countries is explained with reference to aggregate demand.

Aggregate demand

This is the total amount of goods and services demanded in an economy in a given time period and at a given overall price level (Anderton, 2003). Aggregate demand is usually represented by the aggregate demand curve which shows relationship between price levels and quantity of output that firms are willing to offer. Normally, there is a negative relationship between aggregate demand and the price levels. Aggregate demand is composed of various components including: consumer expenditure on goods and services, Investment spent on capital goods, government spending for example on education, exports and imports of goods and services. These components are represented in the following aggregate demand equation:
AD = C+I+G+(X-M) where the extrinsic variables C, I, G, X and M are consumption, investment, government spending, exports and imports respectively (Begg, 2003).
The equation is further written as GDP = C(Y - T) + I(r) + G + NX. C, whish represents consumers’ expenditure on goods and services includes demand for consumer durable and non-durables which are consumed thus qualifies to be repurchased. In the UK, consumer spending contributes about 60% of aggregate demand (Easterly, 2002). To determine consumption expenditure, a consumption function to be used is:
C= a + (mpc) (Y-T) where “a”: is autonomous consumption,
“mpc” is the marginal propensity to consume and “Y-T” is the disposable income. Capital investment, I, is the expenditure on capital goods such as machinery and building for the purposes of investment (O'Sullivan, 2003). Working capital including stocks of both finished and unfinished goods is factored as investment. It therefore represents spending aimed at future production of consumables. According to Keynesian model, there is bound to be a decrease in national output and income in a situation of unplanned investment. For this reason, investment is affected by both output and interest rates. In this context, an increasing interest rate leads to a declined aggregated demand. High interest rate means that the cost of borrowing