The third piece of the aggregate demand equation is I(r). This signifies that
investment spending is a function of the real interest rate. That is, as
the real interest rate increases, investment spending falls because the cost of
borrowing money increases. The real interest rate is simply the nominal
interest rate as published in the media corrected for expected inflation.
When firms consider investment spending, they routinely take into account the
nominal interest rate, inflation, and the real interest rate. Examples of
investment spending include machinery, buildings, education, and new housing.
The fourth piece of the aggregate demand equation is G. Government spending
encompasses every expenditure made by the government. The total amount of money
spent by the government is often surprising. In fact, it is not unusual for
government spending to constitute upwards of one third of gross domestic
product. The level of government spending is a hotly debated topic as
political parties vie for their programs in the annual budget. Examples of
government spending include salaries to government employees, defense spending,
welfare and social security programs, and foreign aid.
The fifth piece of the aggregate demand equation is NX(e). Net exports are
defined as the difference between exports and imports. It is important to
recognize that net exports are dependent upon the real exchange rate. As the
real exchange rate rises, domestic currency is relatively more valuable and thus
the price of domestic goods is relatively more expensive than the price of
foreign goods. In this case, exports fall and imports rise, causing net exports
to decline. Interestingly, a thriving domestic economy will result in a higher
real exchange rate and thus lower net exports. Examples of exports include cars
and electronics made in the US and sold Asian countries. Examples of imports
include fruits and vegetables grown in New Zealand and sold in the US.
The equation for aggregate demand of Y = C(Y - T) + I(r) + G + NX(e) has now
been deciphered. This equation has many meanings such as output, national
income, and GDP. It is difficult, or impossible, to think of economic activity
that is not represented in the aggregate demand equation. This is the idea of
aggregate demand: to capture all economic activity within an economy
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