Aggregate demand

Also called: AD · Topic: Aggregate Demand, Income Determination and the Multiplier · NCERT: Class 12, Ch 4 "Determination of Income and Employment"; Class 12, Ch 5 "Government Budget and the Economy"; Class 12, Ch 6 "Open Economy Macroeconomics"

Meaning

Aggregate demand (AD) is the total ex ante (planned) demand for final goods in an economy at each level of income. It is what households, firms, the government and foreigners together plan to buy.

• Two-sector economy: AD = C + I = C̄ + Ī + cY = Ā + cY
• Three-sector economy: AD = C̄ + Ī + G + c(Y − T)
• Four-sector (open) economy: AD = C̄ + Ī + G + c(Y − T) + X − M

It matters because, in the Keynesian model, AD sets the level of output and jobs. The wage rate does not. [5] When AD falls short, goods stay unsold, firms cut production and workers lose jobs.

Explanation

Where the idea comes from

• The Great Depression (from 1929) is the background.
• In the USA, unemployment rose from about 3% to 25% between 1929 and 1933, and output fell by about one-third. [NCERT leec101]

• Classical economics said markets clear on their own. It could not explain why so many workers stayed jobless for years.

• John Maynard Keynes gave the answer in The General Theory of Employment, Interest and Money (1936). [5]

• His principle of effective demand says that output and employment are set by aggregate demand. [5]

• Ex ante vs ex post. Ex ante means planned. Ex post means actual. AD is always a planned amount, not actual sales.

Components of AD

• C: consumption. C = C̄ + cY.
• C̄ (autonomous consumption) is the spending people must do even at zero income, for food and other basic needs. It is fairly stable.

• c (marginal propensity to consume, MPC) is the share of each extra rupee of income that people spend. 0 < c < 1.

• I: investment. This is spending that adds to the stock of capital: machines, buildings and roads, plus changes in inventory (goods that are made but not yet sold).

• In the model, I = Ī. This is autonomous investment, which means it does not depend on income. On a graph it is a horizontal line.
• Ī is the swing component. It rises and falls with interest rates, credit and business expectations (Keynes called these "animal spirits").

• Keynes treated investment as the key driver of total spending, even though it was usually only one-fifth to one-sixth of total spending. [5]

• G and T: government. G is government spending on goods and services. T is taxes.

• People consume out of disposable income (Y − T), which is the income left after tax.
• A tax of T cuts consumption by only cT, not by the full T, because people would have saved part of that money anyway.

• Rearranged: AD = (C̄ + Ī + G − cT) + cY. So G − cT simply adds to autonomous spending.

• X − M: net exports.

• Exports (X) depend on foreign income, so the model treats them as autonomous.

• Imports (M) rise with domestic income. The part of demand spent on imports leaks abroad and does not support home output. This makes the multiplier smaller.

• Autonomous expenditure (Ā) is all the spending that does not depend on income. In the two-sector model it is Ā = C̄ + Ī. It grows to include G − cT and X when those sectors are added.

The AD line: slope, intercept and shifts

• AD is the vertical sum of the consumption line and the investment line. At each income level, you stack Ī on top of C.
• NCERT figure: OM = C̄ and OJ = Ī, so the intercept is OL = OM + OJ = C̄ + Ī = Ā.
• Slope = c (MPC). This is why the AD line is parallel to the consumption function.
• What moves AD:
• Change in Ā (for example Ī, G or exports rise) → parallel shift up or down.

• Change in c → the line tilts. A higher MPC makes AD steeper.

• The interest-rate channel (why Ī shifts):

• Interest rate falls → loans become cheaper → more projects make a profit → Ī rises → the AD line shifts up.
• Easier credit and more confident firms have the same effect.

Worked example

• Two-sector case. Take C̄ = ₹100 crore, Ī = ₹50 crore and c = 0.8.
• Ā = 100 + 50 = ₹150 crore, so AD = 150 + 0.8Y.
• At Y = ₹1,000 crore, AD = 150 + 800 = ₹950 crore.
• Planned demand (₹950 crore) is less than output (₹1,000 crore). ₹50 crore of goods stay unsold as unplanned inventory. Firms respond by cutting production.

• Output stops changing only when AD = Y: Y = 150 + 0.8Y → Y = ₹750 crore.

• Investment rises. If Ī rises by ₹20 crore to ₹70 crore, AD = 170 + 0.8Y. AD is now ₹20 crore higher at every income level, which is a parallel shift.

• Three-sector case. Add G = 60 and T = 50.
• G − cT = 60 − (0.8 × 50) = 60 − 40 = 20.
• Ā = 100 + 50 + 20 = 170, so AD = 170 + 0.8Y. The slope is still 0.8. Only the intercept is higher.

In India

• Who measures it: MoSPI/NSO publishes GDP by the expenditure approach. This is the real-world version of AD. [2]
• GDP = PFCE + GFCE + GFCF + CIS + Valuables + Exports − Imports [2]
• PFCE (Private Final Consumption Expenditure) = C
• GFCF (Gross Fixed Capital Formation, i.e. spending on new fixed assets) + CIS (Change in Stocks) + Valuables = I
• GFCE (Government Final Consumption Expenditure) = G

• Exports − Imports = X − M

• Size of GDP: nominal GDP was ₹330.68 lakh crore in 2024-25 (Provisional Estimates). [2]

• Shares of GDP (current prices): [2]

Component	2022-23	2023-24	2024-25 (PE)
PFCE (C)	61.5%	60.2%	61.4%
GFCF (fixed investment)	31.2%	30.4%	29.9%
Change in Stocks	1.1%	1.5%	1.5%
GFCE (G)	10.3%	10.3%	10.0%

• Investment is the unstable part. Real Change in Stocks grew 53.4% in 2023-24 but only 4.5% in 2024-25. [2] Real PFCE grew 7.2% in 2024-25, up from 5.6% in 2023-24. [2]
• Net exports pulled AD down: in 2024-25, exports were 21.2% of GDP and imports were 23.5% of GDP. [2]
• The RBI works on Ī. The repo rate is the interest rate at which the RBI lends money to banks for a short time. On 6 June 2025, the Monetary Policy Committee cut it by 50 basis points to 5.50% (1 basis point = 0.01 percentage point). [4]

• Repo rate cut → banks can lower loan rates → firms borrow more cheaply → Ī rises → AD shifts up.

• The government works on G. Union government capital expenditure was ₹2 lakh crore in 2014-15 and ₹11.2 lakh crore in BE 2025-26. It is budgeted at ₹12.2 lakh crore for 2026-27. [3]

Don't confuse with

• Actual (ex post) expenditure: AD is planned spending. Actual spending always equals output, because unsold goods are counted as unplanned inventory investment. Planned AD can be more or less than output.
• Consumption function: it has the same slope (c) as AD, so the two lines are parallel. But its intercept is only C̄, while the AD intercept is C̄ + Ī.
• Autonomous expenditure (Ā): this is only the intercept of AD, the part that does not depend on income. AD = Ā + cY.
• Financial investment: buying existing shares or gold only moves ownership from one person to another. It is not part of I in AD. Only new capital and inventory changes count.

Prelims Hooks

• AD = C̄ + Ī + cY = Ā + cY. Its slope is the MPC (c) and its intercept is C̄ + Ī (OL = OM + OJ).
• A rise in autonomous investment, G or exports causes a parallel upward shift of AD. A rise in the MPC makes AD steeper.
• In the three-sector model, G − cT is added to autonomous expenditure. A tax of T cuts consumption by cT, not T.
• Investment goods are final goods, and inventory change is part of investment. Buying existing shares is not investment.
• Trap: "Keynes held that employment is set by the wage rate." False. He held that it is set by aggregate demand (General Theory, 1936). [5]
• India's expenditure-side GDP (PFCE + GFCE + GFCF + CIS + Valuables + X − M) is published by MoSPI/NSO. PFCE was 61.4% and GFCF was 29.9% of GDP in 2024-25 (PE). [2]

Mains Points

• Public capex as a tool to lift AD, balanced against fiscal discipline.
• Private investment rises and falls with expectations and credit, so the government adds demand directly. Capex rose from ₹2 lakh crore (2014-15) to ₹12.2 lakh crore (BE 2026-27). [3]

• The fiscal deficit (the gap between government spending and its non-borrowed income) is budgeted at 4.3% of GDP (BE 2026-27), down from 4.4% (RE 2025-26). [3] So the push for demand has to fit within a falling deficit.

• Rate cuts alone may not revive investment demand.

• The repo cut to 5.50% (June 2025) makes borrowing cheaper. [4]
• Firms invest only if they need new capacity. So the RBI linked an investment revival to higher capacity utilisation (factories using more of their machines), stronger balance sheets and government capex. [4]

• This matters because GFCF fell from 31.2% (2022-23) to 29.9% (2024-25) of GDP. [2] A lower investment share can limit future capacity and the Viksit Bharat 2047 goal.

• Open-economy leakage.

• Imports (23.5% of GDP) were higher than exports (21.2%) in 2024-25. [2] So part of any rise in domestic demand leaks abroad and the multiplier becomes weaker.
• This supports building domestic manufacturing and capital-goods capacity. It has to be weighed against the gains from trade and the cost of protection.

Related concepts

• Autonomous investment
• Autonomous expenditure
• Two-sector model

Read more

• Investment and aggregate demand