Question

Answer the following question.
State and discuss the components of Aggregate Demand in a two-sector economy.

Answer 1

The components of Aggregate Demand in a two-sector economy are:

1. Private consumption expenditure: Private consumption expenditure refers to the total expenditure incurred by all the households in an economy on different types of final goods and services in order to satisfy their wants. Consumption depends on the level of disposable income. It shares a positive relationship with the level of disposable income, that is, lower the level of disposable income lower will be the purchasing power and hence lower will be the consumption expenditure. The functional form that depicts the relationship between consumption expenditure and the level of disposable income is known as consumption function. There are two types of consumption expenditure- Autonomous Consumption Expenditure and Induced Consumption Expenditure. Autonomous Consumption Expenditure is independent of the level of disposable income, whereas, Induced Consumption Expenditure depends on the level of disposable income.
2. Private investment expenditure: Private investment expenditure refers to the planned (ex-ante) total expenditure incurred by all the private investors on the creation of capital goods such as expenditure incurred on new machinery, tools, buildings, raw materials, etc. This expenditure by all the private investors on the capital goods adds to the total stock of capital thereby increases the overall productive capacity of the economy. Investment depends on the rate of interest and level of income. Broadly, the investment can be categorized into two types- Autonomous Investment Expenditure and Induced Investment Expenditure. The Autonomous Investment Expenditure is independent of the rate of interest and level of income, whereas, the Induced Investment Expenditure depends on the rate of interest and level of income.