By: Mr.

Vipul Budhiraja m: 98151-67577 Page 1

XII ECONOMICS (Session 2023-24)

Macroeconomics
Chapter 7
(Aggregate demand and its components)

1. De ne AGGREGATE DEMAND ?

Aggregate demand (ad) refers to the total value of nal goods and services which all the

sectors of an economy are planning to buy at a given level of income during a period of

one accounting year.

2. Explain the components of aggregate demand?

Components of Aggregate Demand

1. Private (Household) Consumption Expenditure (C): It refers to the total

expenditure incurred by household on purchase of goods and services during an

accounting year. Generally, consumption expenditure is directly in uenced by the level

of ‘ Disposable Income’ i.e .higher the disposable income, more is the consumption

expenditure and vice-versa. Disposable Income refers to the income from all sources,

which is available to households for spending on consumption and saving.

It must be kept in mind that the consumption expenditure we are discussing, is ex-ante,

i.e. planned consumption expenditure.

2. Investment Expenditure (I): It refers to the total expenditure incurred by all private

rms on capital goods. It includes addition to the stock of physical capital assets such as
machinery, equipment, buildings, etc. and change in inventory.

3. Government Expenditure (G): It refers to the total expenditure incurred by

government on consumer goods and capital goods to satisfy the common needs of the

economy. It means, government incurs consumption expenditure as well as investment

expenditure.

• Consumption expenditure is incurred to meet public needs like law and order,

education, health, transport, defense, etc.

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• Investment expenditure involves construction of highways , road, power plants,

etc.

4. Net Exports (X-M): Exports indicate demand for goods produced within the

domestic territory of a country by the rest the world . Imports refer to demands of the

residents of a country for goods that have been produced abroad. the difference

between exports and import is termed as net exports.

Aggregate Demand in a Two – Sector Model ( AD = C + I )

Since the determination of income and employment is to be studied in the context of two

– sector model ( households and rms), the and fourth components of aggregate

demand are not discussed in detail. So, even though AD has four components , we will

assume that AD is a function of only consumption expenditure and investment

Expenditure, i.e. AD = C + I.

3. Explain Aggregate demand using a schedule and a diagram?

or

Explain the relation between income and AD?

AD depends upon the level of income in the economy. Generally . there exists a positive

relationship between income rises, AD also rises and vice-versa. Let us understand this
with the help of

Table and Fig.

Table Aggregate Demand Schedule

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Table and Fig. reveal following noteworthy points about AD:

Important Points about AD

1. AD = C + I: As stated before , AD is assumed to be a function of only consumption

demand and investment demand.

2. Positive consumption , even when income level is zero: There is always some

minimum level of consumption, even when the income is zero. It happens because

people need certain basic goods and services to sustain themselves, even if income is

zero.

In Table ,consumption of Rs 40 crores (when y= 0 ) , is termed as autonomous

consumption . In Fig., consumption curve starts from point S and not from origin. The

positive consumption at zero level of income ( i.e. OS ) indicates the level of

autonomous consumption (c )

3. Slope of Consumption Curve: The rst component of AD , i.e. Consumption curve ,

slope upwards because consumption increases with increase in come . However ,

proportionate increase in consumption is less than that of income. It happens because

after reaching a particular level, people start saving a part of their income.

4. Slope of Autonomous Investment Curve: The second component, investment

expenditure(I), is a straight line parallel to the X-axis as it is assumed to be independent

of the level of income . As seen in Table , investment remains constant at Rs 20 crores .

In Fig. . Or indicates the level of autonomous investment.

5. Starting point AD curve or C+ I curve: Ad curve starts from point T, as at zero level of

national income , AD = Autonomous consumption (OS) + Autonomous Investment (OR).

In Table, AD is Rs 60 crores at zero level of income.

6. Slope of AD curve: AD curve has a positive slope which indicates that as income

increases, AD or aggregate expenditure also increases.

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4. Explain aggregate supply? Explain its components?

Aggregate supply (AS) refers to money value of nal goods and services that all the

producers are willing to supply in an economy in a given time period.

Aggregate supply = National Income

When AS is expressed in physical terms, it refers to total output of goods and services in

an economy. We know that value of total output is distributed to factors of production in

the from of rent, wages, interest and pro t. The sum total of these factor incomes (i.e

rent+wages +interest + pro t) at domestic and national level is termed as National

Income. So, we can say that aggregate supply (AS) and national income (Y), are one and

the same thing.

Components of Aggregate Supply(AS) or National Income(Y)

The major portion of national income is spent on consumption of goods and services

and the balance is saved. It means, Income (Y) is either consumed or saved.

So, National income (Y) = Consumption (C) + Saving (S)

Or, Y = AS = C + S

Diagrammatic Representation of AS

The aggregate supply curve and national income curve coincide with each other. The

nature of National Income curve or AS curve can be made clear with help of Table and
Fig:

Table Aggregate Supply Schedule

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In g. income is represented on the X-axis and consumption and saving are measured

on the Y-axis. A 45o line, which represents the aggregate supply, has been drawn from

the origin. The line is drawn by taking the same scale on both the axes. At every point on

this 45o line, Y = C + S

5. Explain CONSUMPTION FUNCTION (PROPERTY TO CONSUME)?

or

Explain the relation between income and consumption expenditure?

Consumption expenditure refers to that portion of income which is spent on the

purchase of goods and services at the given level of income. Consumption function

refers to functional relationship between consumption and national income.

C = f (Y)

Where, C = consumption; Y = National Income; f = Functional relationship

Consumption function represents the willingness of households to purchase goods and

services at a given level of income during a given time period.

It also shows the consumption level of different levels of income in an economy.

It is a psychological concept as it is in uenced by subjective factors, like consumer’s

preferences, habits etc.

The relationship between consumption and income is shown in Table

Table Consumption Schedule

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Important Observation from Table and Fig

1. Starting Point of consumption curve : Consumption curve (CC) starts from point C

on the Y-axis. This implies that there is autonomous consumption (C) of OC even

when the national income is zero.

2. Slope of consumption curve : CC has a positive slope, which indicates that as

income increases, consumption also arises. However, proportions rise in

consumption is less than proportionate rise in income as part of income is saved.

3. Income is less than consumption : When income is less than consumption (i.e., at

income levels less than OM in Fig. and less than Rs. 200 crores in Table ), the gap is

covered by dissaving (i.e., by utilizing previous saving) ∆COE represents dissaving.

4. Break-even point ( C= Y): At OM level of income (as represents by point E),

consumption becomes equal to income and saving is zero. The point E is Known

as the ‘ Break-even point’. In Table , break-even point occurs corresponding to

income of Rs.200 crores.

5. Income is more than consumption: At points to the right of point E, income is

more than consumption. Excess of income leads to saving. The gap between the

45o line and CC line after point E represents positive Saving.

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6. Explain the types of PROPENSITIES TO CONSUME?

There are two technical aspects of Propensity to consume:

(1)Average Propensity to Consume(APC)

(2)Marginal Propensity to Consume(MPC)

Average Propensity to consume (APC)

Average propensity to consume refers to the ratio of consumption corresponding

level of income.

APC = Consumption (C)

Income (Y)

In table at the income level of Rs.100 crores, APC = 1.20. APC falls to 1 when income
rises to Rs.200 crores. The value of APC further falls to 0.933 and then to 0.90. In g,

income is measured on the X-axis and consumption is measured on the Y-axis. CC is

the consumption curve. APC represents any one point on the consumption.

Important Points about APC

i. APC is more than 1: As long as a consumption is more than national income the

break-even point, APC>1.

ii. APC = 1: At the Break-even Point, consumption is equal to national income.

APC = 1 at the income level of Rs.200 crores.

iii. APC is less than 1: Beyond the break-even point, consumption is less than

income. As a result, APC<1.

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iv. APC falls with increase in income: APC falls continuously with increase in

income.

v. APC can never be zero: APC can be zero only when consumption becomes

zero. Consumption is never zero at any level of income. Even at zero level of

national income, there is autonomous consumption (c).

Marginal Propensity to consume (MPC)

Marginal propensity to consume refers to the ratio of change in consumption

expenditure to change in total income. MPC explains what proportion of change in

income is spent on consumption.

MPC = Change in Consumption (∆C)

Change in Income (∆Y)

Let us understand MPC with the help of following schedule and diagram:

As seen in Table , MPC is 0.80, when consumption increases from Rs.40 crores to Rs.120

crores with increase in income from zero to Rs.100 crores. Value of MPC remains same at

0.80 throughout the consumption function. Since MPC measures the slope of

consumption curve, constant value of MPC indicates that the consumption curve is a

straight line.

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Important Points about MPC

1. Value of MPC varies between 0 and 1: We know, incremental income is either

consumption or saved for future use.

• If the entire additional income is consumed, i.e. ∆S=0, then MPC=1 .

• However, if entire additional income is saved , i.e. ∆C=0, then MPC=0

In normal situations, value of MPC varies between 0 and 1.

[Link] of poor is more than that of rich: It happens because poor people spend a

greater percentage of their increased income on consumption as most of their basic

needs remain unsatis ed.

On the other hand, rich people spend a smaller proportion as they already enjoy a high

standard of living. Similarly, MPC of developing countries like India, Bangladesh , etc. is

more than MPC of developed countries like America or England.

[Link] falls with successive increase in income : It happens because as an economy

becomes richer, it has the tendency to consume smaller percentage of each increment

to its income.

Question: Differentiate between APC and MPC?

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7. Explain SAVING FUNCTION ( PROPENSITY TO SAVE )?

Saving function refers to the functional relationship between saving and national

income.

S = f (Y)

Where, S = Supply; Y = National income; F = Functional relationship

‘Saving Function’ or ‘Propensity to Save’ shows the saving of households at a given level

of income during a given time period. Alternatively to save shows the different levels of

saving at different levels of income in an economy.

The relationship between saving and income is illustrated:

In g., national income is measured on the X-axis and saving is measured on the Y-axis

Important Observations from Saving Schedule and Saving Curve

1. Starting Point of Saving Curve : Saving curve (SS) starts from point S on the Y-

axis, indicating that there is negative saving (equal to amount of autonomous

consumption) when national income is zero.

2. Slope of Saving Curve: SS has a positive slope, which indicates the positive

relationship between saving and income.

3. Break- even point (S = O): Saving curve crosses the X-axis at point R, which is

known to break-even point as at the point, saving is zero (or consumption is equal

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to income). According to Table , break-even point occurs corresponding to income

of Rs. 200 crores.

4. Positive Saving: After the break-even point, saving is positive.

8. Explain the Types of Propensities To Save?

Properties to save are two types:

1. Average propensity to Save (APS)

2. Marginal propensity to Save (MPS)

Average Propensity to Save (APS)

Average propensity to save refers to the ratios of saving to the corresponding level of

income.

APS = Saving (S)

Income (Y)

Table of Average Propensity to Save

In table , APS = (-) 0.20 at the income of Rs.100 crores as there is negative saving of Rs.

20 crores. APS = 0 at income of Rs. 200 crores as saving is zero. In g., income is

measured on the X-axis and saving is measured on the Y-axis.

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Important Points about APS

1. APS can never be 1 or more than 1: As saving can never be equal to or more than

national income.

2. APS can be 0: In Table , APS = 0 as saving are zero at the income level of Rs. 200

crores. This point is known as Break-even point.

3. APS can be negative less than 1: At income level which are lower than the break-

even point, APS can be negative as there will be dissavings in the economy (shown

by the shaded area in g.)

4. APS rises with increase in income: APS rises with increase in income because the

proportion of income saved keeps on increasing.

Marginal Propensity to Save (MPS)

Marginal propensity to save refers to the ratio of change in saving to change in total

income.

MPS = Change in Savings (∆S)

Change in Income (∆Y)

Let us understand MPS through following schedule and diagram:

Table Marginal Propensity to Save

In table , MPS = 0.20 when income increases from zero to Rs. 100 crores. Value of MPS

remains constant at 0.20 throughout the saving function. Since MPS measures the slope

of saving curve, constant value of MPS means

That the saving curve is a straight line.

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MPS varies between 0 and 1

• If the entire additional income is saved, i.e. ∆C = 0 then MPS = 1.

• However, if entire additional income is consumed, i.e. ∆S = 0, then MPS = 0.

In normal situations, value of MPS varies between 0 and 1.

9. Explain the Relationship between APC and APS?

The sum of APC and APS is equal to one. It can be proved as under:

We know: Y = C+S

Dividing both sides by Y, we get

Y=C+S

Y Y Y

1 = APC+APS

10. Explain the Relationship between MPC and MPS?

The sum of MPC and MPS is equal to one. It can be proved as under:

We know: ∆Y = ∆C+∆S

Dividing both sides by ∆Y, we get

∆Y = ∆C + ∆S

∆Y ∆Y ∆Y

1 = MPC+MPS

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Value APC APS MPC MPS

Negative No, due to Ye s , w h e n No, as ∆S No, as ∆C
(less than 0) presence of C > Y , i . e . c a n n e v e r can never
c before BEP. b e m o r e be more
than ∆Y. than ∆Y.
Zero No, due to Ye s , w h e n Yes , when Yes , when
presence of C=Y, i.e. at ∆S = ∆Y ∆C= ∆Y
c BEP.
One Ye s , w h e n No, savings Yes , when Yes , when
C=Y, i.e. at c a n n e v e r ∆C= ∆Y ∆S = ∆Y
BEP. be equal to
income.
More than Ye s , w h e n N o , as No, as ∆C No, as ∆S
one C > Y , i . e . savings can can never can never
before BEP. n e v e r b e be more be more
more than than ∆Y. than ∆Y.
income.

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