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AGGREGATE DEMAND and AGGREGATE SUPPLY

Two theories of Income and Employment determination

1) Classical Theory2) Keynesian Theory

The Classical theory is based on Says Law which says that supply creates its own demand. However

the Says law is based on certain unrealistic assumptions like 1) full employment due to AD being

driven by supply 2) No savings in the economy 3) Perfectly competitive labour and product markets

Keynes believed that full employment rarely existed. Aggregate demand and aggregate supply were

often in disharmony causing full employment impossible.

Aggregate DemandAggregate Demand is the total expenditure of all individuals in an economy during a given time-

period. Following are the components of Aggregate demand:

1) Consumption Expenditure( Both public and private) [C]2) Investment expenditure or demand for capital goods (Both private and Public Investment) [I]3) Net expenditure on trade i.e. Net of Trade Demand (Export-Imports) [X-M]

Aggregate Demand is directly related to income. A higher income implies a higher aggregated

demand. At zero levels of income, AD is not zero as there is always some amount being demanded

or some expenditure in the form of food, clothing etc. (called autonomous expenditure)

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Remember, There is a difference in the definition of aggregate demand in comparison to aggregate

effective demand. Aggregate effective demand is the demand which is met by supply hence clearing

the market of shortages or excesses. Aggregate demand on the other hand is what the public and

private demands, this does not necessarily have to be market clearing.

Let us study the components of Aggregate Demand:

The Consumption function

Individuals do not consume the entire of their income after taxes, they consume a part of it and save

the rest. The proportion of income consumed for every individual is called the marginal propensity

to consume. This proportion is represented by b in the consumption function(C), a is the

autonomous consumption expenditure and Y is the Income.

C = a + b*Y

The value of b lies between zero and one. i.e a proportion of income is always consumed and notthe whole of it. The marginal propensity to consume is different for different levels of income. MPC

is generally high for low income, where a larger part of the income is spent on consumption (of basic

necessities) and is lower for higher income, where the proportion consumed does not change

drastically with successive levels of increase in income.

APC and MPC

Average propensity to consume or APC is the ratio of the total consumption to the total income

APC=

Marginal propensity to consume or MPC is the ratio of the change in consumption due to a change

in income.

MPC=

Income Autonomous

Consumption

Consumption

From Income

Total

Consumption

APC=total.

Cons/income

MPC

C/Y

0 1000 - 1000 - -

2000 1000 1000 2000 2000/2000=1 1000/2000=0.5

4000 1000 2000 3000 3000/4000=0.75 1000/2000=0.5

6000 1000 3000 4000 4000/6000=0.67 1000/2000=0.5

8000 1000 4000 5000 5000/8000=0.63 1000/2000=0.5

Hence MPC decreases/remains constant with an increase in income, The converse that MPC

increases/remains constant with decrease in income is also true. In this table we have shown that

mpc is constant for simplicitys sake (in most cases it is true when the time period is short)

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Relation between APC and MPC

The MPC is the rate of change in the APC. When income increases, the MPC falls but more than the

APC. This is because in the short run as income increases, people generally do not consume a lot

more but add to savings, hence as a result a change in consumption due to change in income is low,

due to which MPC falls faster than the APC.

Conversely, when income falls, the MPC rises and the APC also rises but at a slower rate than the

former. This is because in the short-run some (autonomous) consumption does not change with

income. Fall in income do not lead to reductions in consumption because people reduce savings to

stabilize consumption so hence as income falls APC rises slowly , whereas MPC increases faster

Such changes are only possible during cyclical fluctuations whereas in the short-run there is no

change in the MPC and MPC

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MPS=

Incom

e

Autonomou

sConsumptio

n

Consumptio

nFrom

Income

Total

Consumption

APC=total.

Cons/income

MPC

C/Y

Total

Savings (Y-C)

APS=S/Y MPS=S/Y

0 1000 - 1000 - - -1000 - -

2000 1000 1000 2000 2000/2000=1 1000/2000=0.

5

0 0 0

4000 1000 2000 3000 3000/4000=0.7

5

1000/2000=0.

5

1000 1000/4000=0.2

5

1000/2000=0.

5

6000 1000 3000 4000 4000/6000=0.6

7

1000/2000=0.

5

2000 2000/6000=0.3

3

1000/2000=0.

5

8000 1000 4000 5000 5000/8000=0.6

3

1000/2000=0.

5

3000 3000/8000=0.3

7

1000/2000=0.

5

Hence MPS increases/remains constant with an increase in income, The converse that MPS

decreases/remains constant with decrease in income is also true. In this table we have shown that

mps is constant for simplicitys sake (in most cases it is true when the time period is short)

Also from the above table it is clear that

1) MPC+MPS=12) APC+APS=1

Break even point of consumption and savings

In the upper panel, the Y-curve is the Income curve. It is a 450 line through the origin. CC is the

consumption line and it starts from the Y-axis and not from the origin as there is some amount of

consumption even at zero levels of income. In the lower-panel, the SS curve is the savings curve, and

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it starts from the negative Y-axis as zero income reflects expenditure from previous savings for

consumption. At pointA, the 45 line intersects the consumption curve i.e. at pointA, Income =

Consumption. This implies that whole income is spent on consumption, therefore, saving is zero.

This point is known as break-even point. Corresponding to point A, the point B in the lower panel

represents zero level of savings (S = 0). Thus, we can say that at the break-even point, the economy

is consuming all what it is earning and there are no saving.

The Investment Expenditure/Demand

Investment is the process of creation of new capital assets. Investment expenditure arises when an

individual/firm/govt sees higher returns in using money for building capital assets than putting that

amount in the bank.

Note: Investment in Keynesian Theory refers strictly to capital formation through increase in stock of

capital(machinery, inventory, plants and factories etc). Here financial investments i.e. investment in

securities like mutual funds, shares are not considered.

We have two types of investments:

1) Autonomus Investment2) Induced Investment

Autonomous Investment:

Is the expenditure on capital formation which is independent of the level of Income, rate of interest

or rate of profit. It is always fixed at a minimum level no matter what the level of income, rate of

interest or profit is.

Autonomous investment only changes due to a shift in the economy, like doubling of population,

technological progress etc. An example of autonomous investment may be the government

expenditure on roads and ports to help industries develop in a country.

Induced Investment

Induced Investment is the expenditure on capital assets made with a view of earning profit. Induced

investment increases with a growth in income, as income increases, demand for goods and services

also increases which causes a further increase in demand for investment to meet the demand.

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Marginal Efficiency of Capital (MEC)

Marginal Efficiency of capital is the rate of return at which I would realize my present investment in

capital. For example if I Invest 1,000 rupees and I expect a return of 500 rupees a year for three

years. The rate of return calculated on this expectation would give me the MEC.

Marginal Efficiency of Investment (MEI)

Marginal efficiency of investment is the expected rates of return on investment as additional units of

investment are made under specified conditions and over a stated period of time. A comparison of

these rates with the going rate of interest may be used to indicate the profitability of investment.

As the quantity of investment increases, the rates of return from it may be expected to decrease

because the most profitable projects are undertaken first. Additions to investment will consist of

projects with progressively lower rates of return. Logically, investment would be undertaken as long

as the marginal efficiency of each additional investment exceeded the interest rate. If the interest

rate were higher, investment would be unprofitable because the cost of borrowing the necessary

funds would exceed the returns on the investment. Even if it were unnecessary to borrow funds for

the investment, more profit could be made by lending out the available funds at the going rate of

interest

Net Exports demand

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Net Exports refer to the excess of Exports minus imports. It generally depends on the following:

1) Foreign trade policies between nations2) Relative price of goods to be traded3) National Income of the countries in trade4)

Political relations between the countries in trade

THE AD CURVE

Aggregate Supply

Aggregate supply is the total amount of output produced in the economy. In other words it can also

be broken down into the goods produced and supplied for consumption (C) and the supply of

investible funds which is nothing but Savings. (S)

Y = C+S

In the Short Run the aggregate supply curve (referred to as SRAS) is upward sloping indicating a

positive relationship between the aggregate price level in the economy and the Output level.

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Macro-Economic Equilibrium

Macroeconomic equilibrium for an economy in the short run is established when aggregate

demand intersects with short-run aggregate supply. This is shown in the diagram below

At the price level Pe, the aggregate demand for goods and services is equal to the aggregate supplyof output. The output and the general price level in the economy will tend to adjust towards this

equilibrium position.

If the price level is too high, there will be an excess supply of output. If the price level is below

equilibrium, there will be excess demand in the short run. In both situations there should be a

process taking the economy towards the equilibrium level of output.

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DETERMINATION OF AD-AS EQUILIBRIUM

It is to be noted that both Aggregate demand and Aggregate supply have the same equation,

however the difference comes in the way we view investment. For aggregate demand, the

investment component is the planned investment, whereas for Aggregate supply or GDP it is the

actual investment.

If we are not in equilibrium, then either aggregate demand are too high, or too low. If aggregate

demand are too high, then businesses have to sell off their inventory. This results in higher

investment as businesses produce more to catch up. This means the real GDP increases. Likewise, if

aggregate demand are too low, then businesses build up their inventory. This results in lower

investment as businesses slow down production because warehouses are filling up. This means that

real GDP will decrease.

Note that we will always end up at the equilibrium point, but this 45 degree line can show us howwe get there given current levels of AD and planned vs actual investment.

At the point of AD=AS , we have full employment and Savings-investment equilibrium, it is the

point where the entire resources of the country are employed. If AD>AS we have under-

employment and output or GDP can be increased by increasing more people , whereas when

AD

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KEYNESIAN INVESMENT MULTIPLIER

In general, a multiplier shows how a sum injected into an economy travels and generates more

output.

For example if you buy $100 worth of chips. Say the stallowner saves $10 and spends $90 on

burgers. Then the burger stall owner saves 10% that is $9 and consumes the rest ($81) on cheese,

and so on. For Each $ received 10% is saved (marginal propensity to save- MPS) and 90% consumed

(marginal propensity to consume - MPC). This eventually results in 100/(1-.9)=$1000 worth of

expenditure in the economy.

The multiplier K=1/(1-MPC)

Or

K=1/MPS

Keynes stated that an increase in investment will lead to an increase in output or income. The

multiplier explains how many times the income increases with an increase in in autonomous and

induced investment.

Now, autonomous investment increases for many reasons. People might start believing that better

times are ahead, hence prepare for the future. Another could be that more people decide tobecome entrepreneurs. Another could be government policies that make small loans available for

SMEs.

According to Keynes An incremental increase in investment will lead to an income increase which is

equal to K times the increase in in investment

EXCESS and DEFICIENT DEMAND

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Sufficient Demand

The equilibrium between AD and AS ensures full employment, i.e. a situation where all able bodied

persons willing to work at current wages are employed.

In such a situation resources are fully utilised.

However, If people are unable to find work in the economy at current wages, but want to work, then

a situation known as involuntary unemployment arises.

Deficient Demand

Deficient demand is a situation where there is an excess of Aggregate Supply over aggregatedemand. That is in such a situation people are spending less than what is available in the economy.

In such a case equality of AD and AS takes place at a level which is lower than full employment, this

gives rise to an under-employment equilibrium. i.e in this situation some factors are unemployed in

the economy.

The amount by which Aggregate Demand falls short of Aggregate Supply is measured by the

DEFLATIONORY GAP. Hence the deflationary gap measures the size of deficient demand in the

economy.

Some outcomes of a Deflationary Gap are:

1) Lower equilibrium output or GDP2) Lower Employment levels which are lesser than full employment levels3) Lower or deflated prices due to low aggregate demand in the economy

Deflationary gap can be caused due to the following reasons:

1) Decrease in investment demand or planned investment2) Decrease in public expenditure3) Decrease in consumption demand4) Decrease in disposable income due to higher taxes

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Excess Demand

Excess demand refers to a situation where the level of aggregate demand is greater than the

available aggregate supply in the economy.

The amount by which Aggregate Supply falls short of Aggregate Demand is measured by the

INFLATIONARY GAP. Hence the inflationary gap measures the size of excess demand in the

economy.

The Inflationary gap causes an increase in overall prices of the economy. This is because, once the

economy is at full employment and increase in aggregate demand cannot be absorbed by an

increase in aggregate supply as the resources are all fully utilised. Hence, output and Employment

cannot increase further in the short run, hence just causing prices to rise.

Some outcomes of Excess Demand:

1) Unchanged Equilibrium output in the short run2) Unchanged Employment levels3) Higher or inflated price levels in the economy

Causes of Excess Demand:

1) Increase in investment demand or planned investment2) Increase in consumption demand3) Increase in export demand4) Increase in disposable income due to lowering of taxes5) Increase in government expenditure on public goods6) Increase in consumption expenditure

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FISCAL POLICY AND MONETARY POLICY(Controlling Excess and

Deficient Demand)

To tackle the problems of Excess and Deficient Demand, government of countries undertake two

major macro-economic policies

1) Fiscal Policy2) Monetary Policy

Fiscal Policy

Fiscal policy refers to the macro-economic policy undertaken by the government to promote public

expenditure and collect tax receipts.

For e.g. building of roads and infrastructure conducive for development, Raising taxes from the

public

The government undertakes fiscal policies for the following reasons:

1) Economic Development: Fiscal expenditure on public goods like health care roads etc help ineconomic development

2) Income Inequalities: Progressive taxation is undertaken by the government to tax the richmore and the poor less, this helps in curbing income inequalities

3) Price stability: The government undertakes expenditure through subsidies and minimumprocurement price and so on to maintain price stability and promote farmers. On the other

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hand it subsidies public goods like healthcare etc to make it available to the poorer sections

of the society

More fiscal expenditure is used to tackle deficient demand and less of it used to tackle Excess

demand.

Monetary Policy

Monetary Policy is the policy concerned with controlling the amount of money available in the

economy. It involves both

1) Currency creation2) Credit regulation

The government undertakes monetary policy by the following methods:

1) Issuing of currency notes : Issuing of notes increases monetary supply2) Open Market Operations: Open market Operations refer to the buying and selling of

government bonds and promissory notes. The government buys bonds when it wants more

money supply in the economy and buys bonds when it wants to reduce the money supply in

the economy.

3) Bank Rate regulation: The reserve bank which works on the behalf of the government ofIndia decides on a Bank Rate. The Bank rate is the rate at which the reserve bank lends

money to the commercial banks. The commercial bank then lends money to the public at a

higher rate.

The reserve bank can increase money supply by lowering the bank rate thus enablingcommercial banks to borrow more. To reduce money supply, it can increase the bank rate.

4) Regulation of Cash Reserve: Cash reserve is the amount of Cash retained by the bank out ofthe total deposits made in the bank. If the Cash reserve ratio is lessened then banks can lend

more and the money supply increases. On the other hand if the Cash reserve ratio is raised,

the banks have less to lend and hence money supply is reduced

5) Selective Credit Control: The Reserve banks often direct the commercial banks to practicediscriminatory lending rates. Offering lower interest credits to farmers and higher interest

on housing loans, car loans etc.

The above policies except (5) are used to control excess and deficient demand. These monetary

policies are known as quantitative policies as they either increase or decrease the total volume of

money and credit in the economy. Selective Credit Control is called a Qualitative Policy as it helps

promote the flow of credit into the primary sector of the economy and helps reduce the credit

available for the not so urgent sectors of the economy

Two widely practiced Qualitative measures are:

Controlling Margin Requirements: Margin is defined as the difference between the value of security

and the amount borrowed against that security. RBI can fix different the margin requirements for

different users such that credit is diverted to the essential sectors only. In a situation of excess

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demand RBI raises the margin requirement and hence borrowers would like to borrow less and

money supply would get reduced. Similarly for Deficient Demand RBI would lower the margin to

facilitate borrowing.

Moral Suasion: The word suasion literally means persuasion on moral grounds without any implied

force. The RBI issues a letter to the banks encouraging them to exercise control over creditand grant loans for essential purposes only and not for speculative purposes ( purchasing

private shares and bonds). This enables regulating credit during times of Excess Demand

Any policy that allows availability of more credit or money in the economy or in other words

increases money supply is known as loose monetary policy and is used to correct deficient demand

and deflation.

Any policy that lessens the availability of credit or money or in other words reduces money supply

is known as tight monetary policy and is used to correct excess demand and inflation