Chapter 25: Problem 871

What is the rationale of subtracting expenditures for imports in measuring aggregate demand as compared to adding exports as a new component of aggregate demand?

Short Answer

Expert verified

The rationale for subtracting import expenditures and adding exports in the measurement of aggregate demand is to accurately represent the total demand for goods and services within a country. Adding exports captures the positive impact of domestic production on the economy, while subtracting imports removes the demand directed towards foreign producers. This method provides a more reliable measure of aggregate demand, reflecting the actual contribution of domestic production and external trade to the economy.

Step by step solution

Define Aggregate Demand and Its Components

Aggregate demand is the total demand for all goods and services in an economy. It comprises four major components: consumption (C), investment (I), government spending (G), and net exports (X - M), where X stands for exports and M stands for imports. So, the aggregate demand can be represented by the equation: AD = C + I + G + (X - M).

Role of Imports and Exports in Aggregate Demand

Imports and exports are essential components of a country's economy that directly affect the aggregate demand. Exports represent the goods and services produced domestically and consumed by other countries, whereas imports are the goods and services produced by other countries and consumed domestically.

Adding Exports to Aggregate Demand

When goods and services are produced within a country and sold to foreign buyers, they contribute to the domestic production and increase the nation's total income. Therefore, adding exports as a new component of aggregate demand helps to capture the positive impact of these transactions on the country's economy. Exports directly affect the aggregate demand by increasing it, as they represent additional demand for domestic goods and services.

Subtracting Imports from Aggregate Demand

On the other hand, imports represent goods and services that are produced abroad and consumed domestically. These goods and services do not directly contribute to the domestic production of a country, and their consumption has no direct effect on the total demand for domestically-produced goods and services. When we subtract the expenditure for imports from the aggregate demand, we remove the demand that is directed towards foreign producers and not domestic ones. Thus, subtracting imports from aggregate demand helps in accurately reflecting the total demand for goods and services produced within the country.

Conclusion

In conclusion, subtracting expenditures for imports and adding exports as a new component of aggregate demand is a rational approach to measuring the total demand for goods and services within a country accurately. This method reflects the actual contribution of domestic production and external trade to the economy, hence providing a more reliable measure of aggregate demand.