Aggregate demand

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The Concept of Aggregate

Demand In India

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What is Aggregate Demand

Aggregate demand refers to the total amount that different sectors in the economy are willing to spend in a given period.

It is the sum spending by consumers, businessmen, Government and other agencies in the country i.e. It measures the total spending by all different entities in the economy.

It depends upon:Level of pricesMonetary policyFiscal policyOther factors

Source: Introductory Economic Theory XII – 7th edition

3

Determinants of aggregate demand

AD = C + I + G + (X-M)Where; AD = Aggregate demand

C = Consumption

I = Investment

G = Government

demand

(X-M) = (Export – Import) i.e. Net

income from foreign

transactionsSource: Introductory Economic Theory XII – 7th edition

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A. Consumption (C)The amount which consumers are willing to spend on the purchase of goods and services for satisfaction of their wants

Those goods & services which are utilized for final satisfaction of human wants E.g. TV, car, rice, milk

Consumption depends on the following factors:

Level of household income Credit facilitiesOutlook for futureDisposable incomeStock of wealthAdvertisementAvailability of goods & servicesCultural attitudeAverage size and composition of householdsSource: Introductory Economic Theory XII – 7th edition

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B. Investment DemandThe use of saving for the purpose of production made by an individual or a business firm.

Aim: acquire capital goods or assets E.g. Machinery plant, factory buildings etc.

Investment expenditure also made by Govt. To increase stock of Social and economic overheads

Types:

Private investment

Public investment

Foreign investment

Gross investment

Net investment

Induced investment

Autonomous

investment

Source: Introductory Economic Theory XII – 7th edition

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B. Investment Demand

DETERMINANTS

Level of saving

Rate of interest

Marginal efficiency of capital

Supply of money

and bank credit

Innovation and

technology advance

Stock of fixed

capital

Expectation about future

changes

Source: Introductory Economic Theory XII – 7th edition

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C. Government Demand

Government Expenditure

Consumption Expenditure by

Govt.

Investment expenditure by

Govt.

When these expenditures are incurred by the Govt, it increases aggregate demand. When the Govt makes payment for goods and services purchased and when the amount received by factors of production is used by factors for purchase of goods & services produced in the country, it increases the demand for goods & services.Source: Introductory Economic Theory XII – 7th edition

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D. Foreign Demand (X-M)

Export: Selling of goods & services – capital & consumer goods by one country to different countries of the world

Import: Purchase of goods & services – capital & consumer goods by a country from different countries in the world. Increases agg. demand

Net earnings from foreign transaction: Export – Import This can be positive, negative or even zero

Source: Introductory Economic Theory XII – 7th edition

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Consumption goods & services by the private sector (C)

Consumption & Investment goods and services by Government (G)

Consumption & investment goods and services by foreigners (X)

Private Sector Demand

Public Sector Demand

Net External Sector Demand

+ + +

Total Spending On

-All Imports(M)

Aggregate Demand = C + I + G + (X – M)

Investment goods and services by the private sector (I)

Components of aggregate demand

10Source: indiabudget.nic.in/es2009-10/chapt2010/chapter01.pdf

Change in Aggregate Demand over the years

Source: indiabudget.nic.in/es2009-10/chapt2010/chapter01.pdf

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Causes of changes in Aggregate Demand

Changes in the monetary policy Fluctuations in the exchange

rate Consumer confidence Changes in the economic conditions of other

countries Fiscal policy Taxes and aggregate demand

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Demand side shocks Capital investment boom Rise or fall in the exchange rate Consumer boom abroad in the country of one of our

major trading partners

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Computation of aggregate demand

Formula: Aggregate Demand (AD) = C + I + G + (X-M)

Example

For the year 2007- 2008 C = Rs 30 cores I = Rs 44 cores G = Rs 20 cores (X-M) = Rs -3 cores

Aggregate demand = 30 +44 + 20 +( - 3)Aggregate demand = Rs 91 coresGDP = 9.1 %

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ExplanationTill 2006-07 the most contributing

component in aggregate demand was investments

In 2007-08 along with investments the consumer expenditure was also higher than previous years

The external trade made negligible or negative contribution.

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Difference between GDP and AD

Aggregate demand curve explains the level of goods demanded at each price level

GDP is actual level of goods exchanged

One is the curve, the other is the actual point of intersection

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Downward Sloping Demand Curve

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Main Reasons behind the downward sloping demand curve

The Price Level and Consumption: The Wealth Effect

The Price Level and Investment: The Interest Rate Effect

The Price Level and Net Exports: The Exchange - Rate Effect

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The Wealth Effect

• A decrease in the price level makes consumers feel more wealthy, which in turn encourages them to spend more

• This increase in consumer spending means larger quantities of goods and services demanded

The Interest Rate Effect

• A lower price level reduces the interest rate, which encourages greater spending on investment goods

• This increase in investment spending means a larger quantity of goods and services demanded

The Exchange-Rate Effect

• When a fall in the price level causes INDIA’s interest rates to fall, the real exchange rate depreciates, which stimulates U.S. net exports

• The increase in net export spending means a larger quantity of goods and services demanded

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Shifts in Aggregate Demand Curve &

factors causing the shift

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Shift in Aggregate Demand Curve

RightLeft

AD1 AD2AD3

Price Level

Real GDP

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Shift Arising from Consumption

Exogenous factors affecting consumption◦ Tax rates◦ Incomes – short term and expected

income over lifetime◦ Wage increases◦ Wealth

Property Shares Savings Bonds

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Shift Arising from Investment Spending on:

◦ Machinery◦ Equipment◦ Buildings◦ Infrastructure

Influenced by:◦ Expected rates of

return◦ Interest rates◦ Expectations of

future sales

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Shift Arising from Government PurchaseDefenceHealthSocial WelfareEducationForeign AidRegionsIndustryLaw and Order

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Shift Arising from Net exports

RecessionMovements in

the exchange Rate

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Contractionary monetary policyMs AD curve shifts to the left

Contractionary fiscal policyG AD curve shifts to the left

T AD curve shifts to the left

Expansionary monetary policyMs AD curve shifts to the right

Expansionary fiscal policyG AD curve shifts to the right

T AD curve shifts to the right

Shifts in the Aggregate Demand Curve: A Summary

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Demand Scenario in the Indian Economy

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Positive Features

Negative Features

Higher Growth

Change in Life style

Demographic Changes

Growing Regional Inequality

Uneven Sectoral Growth

Signals Current Demand

Signal Potential Demand/Problems

Recent trends in the Indian economy

Source: Macro-economic policy environment ; Shyamal Roy

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India: Sectoral share of GDP, 1990-91 to 2005-06

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

1990-91

1991-92

1992-93

1993-94

1994-95

1995-96

1996-97

1997-98

1998-99

1999-00

2000-01

2001-02

2002-03

2003-04

2004-05

2005-06

Perc

enta

ge o

f GD

P

Services share Industry Share Agriculture Share

Source: Macro-economic policy environment ; Shyamal Roy

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India: GDP Growth, 1991-92 to 2005-06

1.3

5.12

5.9

7.25 7.347.84

4.79

6.51 6.36

4.37

5.79

3.77

8.51

7.53

8.43

0

1

2

3

4

5

6

7

8

9

1991-92

1992-93

1993-94

1994-95

1995-96

1996-97

1997-98

1998-99

1999-00

2000-01

2001-02

2002-03

2003-04

2004-05

2005-06

% c

hang

e pe

r ann

um

Source: Macro-economic policy environment ; Shyamal Roy

31

India: Overall and Sectoral GDP growth, 1990-91 to 2005-06

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

1991-92

1992-93

1993-94

1994-95

1995-96

1996-97

1997-98

1998-99

1999-00

2000-01

2001-02

2002-03

2003-04

2004-05

2005-06%

per

ann

um

GDP Services Industry Agriculture

Source: Macro-economic policy environment ; Shyamal Roy

32

A disaggregated look , gives the following picture:•Services sector (62%) has been impressive and

largely domestic demand driven• Industry (19%), showed a sluggish growth rate but

has since revived.•Agricultural sector (19%) continues to be random,

depending on weather

Disaggregated look

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• Indian GDP growth has been largely propelled by the growth of the service sector

• The service sector growth and, thus, the overall growth is unsustainable unless the other two sectors of the economy also register a higher growth

• Sustained growth in industry and a turnaround in agriculture is constrained by lack of investment in infrastructure

• Investment in infrastructure, thus, holds the key to sustained growth of GDP in India

Analysis of growth

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Sector Share

Agriculture 19%

Industry 20%

Services 61%

All 100%

State of the Indian economy today

Source: Macro-economic policy environment ; Shyamal Roy

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Understanding the global context

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Global Economic Structure Today• US, Japan and the European region account for more than 60% of global GDP

• Substantial part of the rest of the world’s GDP growth is driven by what happens in the above countries

• India and China are different

37

Global Economic Prospects•US economic is on the path of recovery however,

not without certain concerns•Europe and Japan still have some ways to go in

terms of sustained recovery•China is doing well and is substituting US, Japan,

and Europe, to some extent, in terms of providing market for other country's products

• India is the other country which is doing well and is attracting lot of business interest from abroad

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Special Cases of China and India

•Both are large economies with a large domestic market

•They are the fastest and second fastest growing economies, respectively, in the world today

•Both have a huge potential for growth•Both are attracting considerable investment interest from abroad

•Both are capable of considerably tilting the balance against excessive dependence on west, particularly, the US

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India: Problems and Prospects

• Structural rigidities, lack of infrastructural support have been the key bottlenecks

• Coalition politics dictates the pace of change

• However, no policy uncertainty• Substantial rise in investment in infrastructure which is crowding in rather than crowding out private sector investment

•Offers tremendous potential in knowledge based industries

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China: Problems and Prospects

• Financial Sector extremely fragile and highly vulnerable

• Piracy rampant• Structural rigidities•Philosophical question remains as to how long a communist government will be able to foster market driven policies in the face of growing inequalities

• However, infrastructure highly developed• Government hassles least

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What’s in store for the future ?

• Global investment interests may shift towards non- Japan Asia, including South Asia in the short run

• US and some other countries may be tempted to resort to protectionist measures

• The biggest threat to globalization and free trade may come from return of protectionism

• Hopefully, long term considerations will outweigh short term economic pressures

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Bibliography http://www.cliffsnotes.com/study_guide/Aggregate-De

mand-AD-Curve.topicArticleId-9789,articleId-9737.html

http://tutor2u.net/economics/revision-notes/as-macro-aggregate-demand.html\

http://indiabudget.nic.in/

http://indiabudget.nic.in/es2008-09/seconomy.htm

Introductory Economic Theory, 7th edition

Macroeconomic policy environment, Shyamal Roy

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