AGGREGATE DEMAND,
AGGREGATE SUPPLY AND
RELATED CONCEPTS
Chapter 7
AGGREGATE DEMAND (AD)
It refers to the sum total of expenditure that the people plan to incur
on the purchase of goods and services produced in the economy
during the period of an accounting year corresponding to their
different levels of income.
In a two sector economy
AD= C + I
Where, C = Household consumption Expenditure
I = Producer’s investment Expenditure
COMPONENTS OF AGGREGATE DEMAND IN
AN OPEN ECONOMY
• Household (Private) consumption expenditure (C)
The total expenditure incurred by all the households of the country on their
personal consumption is called private consumption expenditure or private
consumption demand. Consumption demand depends mainly on disposable income
and propensity to consume.
• Investment Expenditure (I)
It refers to the demand for capital goods by the private sector. It is the total
expenditure incurred by the producing sector for the investment such as purchase
of capital goods, plant, machinery, factory building, inventories etc. Generally
investment expenditure is of two types:
• Induced investment and Autonomous investment
• Government Expenditure (G)
• It is the total expenditure incurred by government on consumption and
investment. The government makes consumption expenditure on behalf of the
society as a whole such as provision for education, health, compensation of
employees, law and order, justice, security etc. It also makes investment
expenditure such as expenditure on roads and bridges, railways, canals, dams
etc. Government expenditure is affected by government policy.
COMPONENTS OF AGGREGATE DEMAND IN
A CLOSED ECONOMY
Apart from the above components there is one more component of AD in an open
economy.
Net exports ( X – M)
It is the difference between exports and imports of goods and services. It shows
the effect of domestic spending on foreign goods and services (M) and foreign
spending on domestic goods and services (X) on the level of aggregate demand.
• Hence, in an open economy
AD = C + I + G + (X – M)
• In a two sector closed economy
AD = C + I
• In a three sector closed economy
AD = C + I + G
BEHAVIOUR OF AGGREGATE DEMAND
• Thebehavior of aggregate demand means how aggregate
expenditure responds to different levels of income in the economy.
• Thereexists a positive relationship between income and the level
of aggregate expenditure in the economy, i.e. as the level of
income rises, aggregate demand also rises and vice versa. This
can be explained with the help of following schedule:
Income (Y) Aggregate
Demand
From the schedule it is observed that: (Planned
• There is always some minimum level of expenditure in expenditure)
the economy even when income is zero (Y = 0). Thus AD 0 30
= 30 when Y = 0. This is the expenditure for survival. 20 35
• AD increases as Y increases. Thus AD is positively 40 40
related to Y. 60 45
• After a certain level of income is reached AD lags behind 80 50
Y. This happens because at higher level of income
100 55
people start saving a part of their income
AGGREGATE DEMAND(AD)
CURVE
The graphical presentation of aggregate demand schedule
gives us the aggregate demand curve. From AD schedule
and AD curve it is clear that AD increases with the increase
in income.
AGGREGATE SUPPLY (AS)
• Aggregate supply refers to the total quantity of goods and services
that all the producers are planning to produce in an economy
during an accounting year.
Aggregate Supply = National Income (Y)
• Producers make payments to factors of production for their
services in production. This payment is factor cost from producer’s
point of view and factor income from factor owner’s angle.
Production of goods and services implies value addition and value
addition means income generation. Accordingly, AS implies flow of
income in the economy during an accounting year. Therefore, AS
= National Income.
• Aswe know income is either consumed or saved. Hence, according
to Keynes, AS = C + S = Y (National Income)
AS Schedule can be obtained by adding consumption schedule and
saving schedule.
AS Schedule AS Curve
Income (Y) Consumption Saving (S) AS = C + S
(C)
0 20 ─ 20 0
50 60 ─ 10 50
100 100 0 100
150 140 10 150
In the figure AS curve is shown having an angle of 45 degree. It is also known as line of
reference or income curve in Keynesian economics.
Consumption function
• Thefunctional relationship between income and consumption is called
consumption function.
C = f (Y) ; Where, C = Consumption, Y = Income
• The consumption function can be explained with the help of following table
The three main points of consumption function are
• There is always some minimum level of consumption even when income is 0
(zero). In the table 20 is the minimum level of consumption. This is called
autonomous consumption. It leads to negative saving or dissaving.
• Consumption is positively related to income.
• The entire increase in income during a particular period is not converted into
consumption because a part of income is saved as well. So the rate at which C
increases is less than the rate at which Y increases.
Consumption • In the figure, consumption is measured on
Curve the Y-axis and income on the X- axis.
• A line making an angle of 45 degree and
shooting from the origin is drawn as a line
of reference.
• It indicates the equality between
consumption and income. Consumption
curve CC starts from the point C on Y
axis. This means that there is
autonomous consumption (C̅) of OC even
when the income is zero.
• CC has a positive slope which indicates
that as income increases consumption
also increases.
• At OM level of income, consumption =
income and it is represented by point E.
This point is known as break-even point.
• Before break-even point, C > Y and
therefore negative saving or dissaving.
After point E, Y > C which results in
positive saving.
Slope of Consumption
Curve
Slope of consumption curve =
Algebric Equation of Consumption function
C = C̅ + bY
Here, C̅ = Autonomous consumption
Y = National income
b = Marginal propensity to consume =
slope of consumption curve ( )
Marginal propensity to consume is nothing but
the slope of consumption curve ()
Thus, C = Autonomous consumption (C̅) +
Induced consumption (bY)
PROPENSITY TO CONSUME
• Itrefers to the proportion of income that spent on consumption. It
is of two types:
Average propensity to consume (APC)
Marginal propensity to consume (MPC)
• Average propensity to consume (APC)
It refers to the proportion of total income that goes to consumption
expenditure. It is the ratio between total consumption(C) and total
income(Y).
APC =
Income (Y) (₹) Consumption (C) (₹) APC =
0 20 =∞
50 60 =1.2
100 100 =1
150 140 =0.93
So, When Y < C, APC > 1
When Y = C, APC = 1
When Y > C, APC < 1
APC fall with the increase in income. It is because proportion of
income spent on consumption keeps on falling as people tend to
save more with the increase in income.
APC can never be zero because consumption is never zero. Even
at zero level of income, autonomous consumption is there.
Marginal propensity to consume (MPC)
• It
refers to proportion of additional income that goes to
consumption expenditure. In other words, MPC is the ratio between
change in consumption and change in income.
MPC =
Here, ∆C = Change in consumption
∆Y = Change in income
Income (Y) (₹) Consumption (C) (₹) MPC =
0 20 ─
50 60 =0.8
100 100 =0.8
150 140 =0.8
• The value of MPC generally lies in between 0 and 1. i.e. 0 <
MPC < 1
• If entire additional income is spent, ∆C = ∆Y, MPC = 1
• If the entire additional income is saved then ∆C = 0, implying
MPC = 0
• MPC of developing countries is more than MPC of developed
countries as developing countries need to spend on basic
needs more than developed countries.
SAVING FUNCTION
• Thefunctional relationship between income and saving is called
saving function. It is expressed as
S = f (Y)
• Here, S = Saving, Y = Income
Since, Income = Consumption + Saving
Y=C+S
Therefore, S = Y ─ C
So, once C-function is specified, S-function can be easily derived
from it.
Saving Schedule Saving Curve
Income (Y) Consumption (C) Saving (S = Y ─ C)
0 20 ─ 20
50 60 ─ 10
100 100 0
150 140 10
The above table reveals that
• S = ─ 20 when Y = 0. This is because C = 20
when Y = 0 and we know that Y = C + S. In the figure saving is measured on the
• S increases as Y increases implying that Y-axis and income on the X-axis.
saving is positively related to income. • The SS line starts from ─ 20 on Y –axis
• Saving always remains lower than income. indicating that S = ─ 20 when Y = 0.
It is never greater than income because it • The SS line is positively sloped
is only a part of income. representing direct relation between
income and saving.
• Saving line crosses the X-axis when
income = 100. It indicates that saving
= 0 when Y = C.
Slope of saving line (Marginal
propensity to save)
Slope of saving curve (MPS) =
Algebric equation of saving function
We know that,
Y=C+S
Or, S = Y ─ C
= Y ─ { C̅ + bY}
= Y ─ C̅ ─ bY
= ─ C̅ + Y ─ bY
S = ─ C̅ + (1 ─ b)Y
Here, ─ C̅ = Negative saving or
Dissaving
(1 ─ b) = Marginal propensity to
save
Propensity to Save
It refers to the proportion of income that goes to saving. It is of two
types
• Average propensity to save (APS)
• Marginal propensity to save (MPS)
• Average propensity to save (APS)
It refers to the proportion of total income that goes to saving. It is
the ratio between total saving and total income.
APS =
Income (Y) Consumption (C) Saving (S = Y ─ APS =
C)
0 20 ─ 20
50 60 ─ 10
100 100 0
150 140 10
When Y < C, S = ─ve, APS = ─ve
When Y = C, S = 0, APS = 0
When Y > C, S = +ve, APS = +ve but less than 1
because saving is only a part of income.
Marginal propensity to save (MPS)
• It
refers to the proportion of additional income that goes to saving.
In other words, it is the ratio between change in saving and change
in income.
MPS =
Income (Y) Consumption (C) Saving (S = Y ─ C) MPS =
0 20 ─ 20 ─
50 60 ─ 10
100 100 0
150 140 10
In case of linear saving function, MPS will be constant. For any linear curve,
slope is constant and MPS is nothing but the slope of saving curve.
Relationship between propensity to consume and
propensity to save
APC + APS = 1
We know that, Y = C + S
Dividing both sides by Y, we have
Or, 1 = APC + APS
MPC + MPS = 1
We know that, Y = C + S
Now, ∆Y = ∆C + ∆S
Dividing both sides by ∆Y, we have
Or, 1 = MPC + MPS
Derivation of saving curve
from consumption curve
Given the CC consumption curve and OY
income curve, we derive saving curve as
following
• We take OS = OC as OC is autonomous
consumption (C̅) defined at zero level of
income. It implies that saving at zero level
of income will be OS (─ C̅). Thus we get a
point on negative Y axis from where the
saving curve will start
• Point E on consumption curve indicates
break-even point (C=Y) implying APC = 1
and zero savings. Hence saving curve will
intersect X-axis at point E1.
• We join points S and E1 and by extending
the straight line upwards we get the
saving curve SS.
Derivation of
consumption curve from
saving curve
Given that SS is the saving curve. We derive
consumption curve as follows
• We draw a 45 degree line from the origin
OY, the income curve.
• We take OC = OS, OS being the amount of
dissaving (─ C̅). It implies autonomous
consumption (C̅). Thus we get a point C on
Y-axis from where the consumption curve
will start.
• Point E1 indicates zero savings. Hence
consumption curve will intersect the income
curve at point E implying consumption
equal to income.
• We join points C and E and extend upwards
to get You
Note: consumption
need to curve
draw CC.
the same figure
in both the case ,only the explanation
will be different.
Autonomous investment and Induced investment
• Expenditure on capital goods which • Induced investment is that level
is independent of the level of income of investment which depends on
and not influenced by expected the level of income and
profitability is called autonomous motivated by expected
investment. In other words, it is not profitability. It is positively
affected by changes in the level of related to the level of income. It
income and induced by profit is done by the private sector.
motive. Autonomous investments
are generally made by the
government.
