The total expenditure of an economy can be divided in to four categories of spending. They are consumption expenditure (C), investment expenditure (I), government expenditure (G) and net expenditure on trade or net exports that is, exports minus imports, (X-M). The aggregate demand is the sum total of all such spending. Hence the aggregate demand function is represented as
AD = C+ I + G + (X-M) ... ... (1)
This function shows that the aggregate demand is equal to the sum of expenditure respectively on consumption (C), Investment (I), Government spending (G) and net exports (X-M). Thus aaggregate demand is the total value of all planned expenditure of all buyers in the economy. It is the total demand for goods and services in the economy
(Y) in a specific time period. Moreover, the aggregate demand is known as the amount of commodities people want to buy.
In the economy, as one man's expenditure is another man's income, the total expenditure of the economy must be equivalent to the total income. That is Total income(Y) = Total expenditure (AD). Since Y = AD, equation ( 1) can be written as
Y = AD = C+ I + G + (X-M)
or Y = C+ I + G + (X-M)
Keynes gives all attention to the ADF. This aspect was neglected by economists for over 100 years. Assuming that ASF is constant, the main basis of Keynesian theory is that employment depends on aggregate demand which itself depends on two factors :
1. Propensity to consume (Consumption function)
2. Inducement to invest (Investment function).
Investment has a specific meaning in economics. It means additions to the existing productive capacities (stock of fixed capital and inventories). They include fixed equipments, machinery, building, raw materials, replacement due to depreciation, etc. It lays down the basis for future production. Investment is the key structural component of total spending or aggregate spending.
By investment, Keynes means real investment and not financial investment. Investment is the addition to real capital assets. It does not mean the purchase of bonds or shares which are financial investment. The distinction between consumption and investment is fundamental in Keynesian theory. Importance of investment as a component of aggregate demand rises due to the fact that it is another major component.
Consumption is a stable function of income. So it was not possible to change aggregate demand by changing consumption expenditure as it depends on income. Keynes found that investment is an autonomous expenditure determined independently of the level of income. He found it to be the major cause for the variation and instability in income and employment. The worldwide depression of 1930s was also caused by a fall in investment.
According to Keynes, employment depends on investment. Employment fluctuates on account of fluctuations in investment. Therefore, we must discuss what determines the amount of investment. Investment spending is determined by
1. Expectations of future profitability or business confidence and
2. Rate of interest
Firms invest either from their own profits or by borrowing. Households having saving, have to decide whether to invest the money for profit or lend/deposit for interest. If the expected profit is higher than the rate of interest, then the households will invest. Otherwise they will lend or deposit their money for interest. Firms who invest their own profit will also decide in the same manner. Suppose the firms borrow for investment, then they have to pay interest for that. Hence, firms will invest borrowed money only when the expected profit is high enough to pay the interest and the cost of initial capital.
Thus, in all the above cases, the decision to invest will be based on the rate of interest and business confidence. Of these two, business confidence or expectations about future profitability has got greater significance than the rate of interest. This is because rate of interest is stable in the short run. The expectations about profitability involves several considerations of the future about which there cannot be any certainty. Bleak prospects will lead to a reduction of investment and it will affect employment and vice versa.
Another important concept in this regard is savings. It is directly connected with investment. Saving and investment are the basic economic activities of an economy. Saving is inevitable for capital formation and economic growth. Saving itself has nothing to do with economic growth unless savings are properly mobilized and effectively channelised and invested to enhance capital stock to increase production and wealth of the economy. Thus aggregate savings and investment are equal.
But they may not be always in equilibrium. The classical economists believed that savings were automatically invested. They thought the decisions to save and the decisions to invest were made by the same persons. But Keynes argued that saving and investment were made by different persons for different reasons and were influenced by different factors. Thus, sometimes savings might exceed investment. When this happened, there would be deficiency of aggregate demand and general unemployment.
Keynes thought the gap between S and I could be filled by government intervention either directly by increasing government expenditure or indirectly by actions influencing the supply of money Thus S = I
Therefore Y = C + I
Or Y = C + S
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