Aggregate Demand and Aggregate Supply
Aggregate Demand and Aggregate Supply
Aggregate Demand: It refers to
the total value of final goods and services which all the sectors of an economy
are planning to buy at a given level of income during a period of an accounting
year. It is measured in the terms of total expenditure on goods and services of
households, firms, government of the economy. Or we can say that it is aggregate expenditure on consumption and
investment that all sectors of the economy are willing to incur at each income
level. Thus, the term aggregate demand and aggregate expenditure are used
interchangeably. It is a flow concept as it is generally measured for an
accounting period. It refers to a planned expenditure and not the actual
expenditure.
Aggregate Demand is denoted by AD.
According to Keynes,
aggregate demand refers to the total amount of money, that the buyers are ready
to spend on goods and services, produced in an economy during a given period.
Components of Aggregate Demand:
1-Private (household) consumption
expenditure: it
refers to total expenditure incurred by households on purchase of goods and
services during an accounting year. Consumption demand depends mainly on disposable income [the
amount of money that a household has to spend or save after the deduction of
income taxes is disposable income.] and propensity to consume. It is denoted by C.
2-Investment expenditure: it refers to the total
expenditure incurred by all the private investors on capital goods like machines, plant, equipment, etc to
increase the production capacity. It includes addition to the stock of physical
capital assets. Investment’s demand depends upon
marginal efficiency of capital and interest rate. It is denoted
by I.
Investment is of two types, Autonomous Investment and Induced
investment, but in Keynes theory investment is assumed to be Autonomous.
The basic difference between Induced Investment and
Autonomous Investment:
·
Induced
Investment: Induced investment is profit or
income motivated. It is positively related with income. When income increases,
consumption demand also increases, as a result, investment increases. Thus,
induced investment is a function of income I = f(Y).
It
is income elastic and increases or decreases with the rise or fall in income.
Generally, it is done in a private sector.
·
Autonomous
Investment: it is independent of the level
of income that’s why it is income inelastic. It is influenced by exogenous
factors like innovations, inventions, growth of population, social and legal
institutions, revolution, etc. Such investment includes expenditure on
building, dams, roads, canals, schools, hospitals, etc. Autonomous investment
is regarded as public investment as it is generally done in government sector.
For
simplicity, it is assumed that investment expenditure is autonomous and not
influenced by the level of income.
3-Government expenditure: it refers to the total
expenditure incurred by the government on consumption expenditure (such as education,
health, transport, defence, law and order, etc) and investment expenditure (such
as roads, infrastructure, power plants, etc.) to satisfy the common needs of
the economy. It is denoted by G.
4- Net Exports: it refers to the difference between
exports and imports. Exports indicate demand for goods produced within domestic
territory of a country by rest of the world while imports indicate to the
demand of the residents of a country for the goods that have been produced
abroad. Net exports depend upon many
things like Foreign Trade Policy, Foreign Exchange Rate, etc.
Net Exports= Exports- Imports
(X-M)
Thus, Aggregate Demand = C+I+G+(X-M)
Aggregate
demand in two sector model: In
a two-sector economy [households and firms], we ignore government expenditure
and net exports and include only consumption expenditure
and investment expenditure that is AD=C+I.
Aggregate
demand depends upon the level of income and there is a positive relation
between income and aggregate demand in the economy.
Aggregate Demand Schedule
|
Income [Y] In lakhs |
Consumption[C] In lakhs |
Investment[I] In lakhs |
AD= C+I In lakhs |
|
0 |
40 |
40 |
80 |
|
100 |
120 |
40 |
160 |
|
200 |
200 |
40 |
240 |
|
300 |
280 |
40 |
320 |
|
400 |
360 |
40 |
400 |
|
500 |
440 |
40 |
480 |
Important points about aggregate demand schedule and diagram-
· Aggregate demand is the
total of consumption expenditure and investment expenditure AD=C+I
· There is minimum level of
consumption even if the income is zero. It is called autonomous consumption and
is denoted by:
· The slope of consumption curve
is upwards from left to right because consumption increases with the increase in
income. Increase in consumption becomes
less than increase in income after a certain point because people start saving as
the level of income increase.
· Investment expenditure is
autonomous and is not influenced with income that’s why it is parallel to
X-axis.
· Aggregate demand curve has a
positive slope which shows that aggregate demand increases with the increase in
income.
Aggregate Supply: Aggregate supply refers to money value of final goods
and services that the firms are willing to supply in an economy in an
accounting period. It
refers to the total production of goods and services in an economy. Aggregate
supply of goods of an economy depends upon the stock of capital, the amount of
labour used and the state of technology. In the short run, stock of capital and
technology remains constant and therefore output can be increased by increasing
the amount of labour employed. Thus, each level
of employment involves certain money costs of production including normal
profits which the entrepreneur must cover. The value of total output is
distributed to the factors of production in the form of wages, rent, interest
and profits. It represents the national income of a country during a period of
time because the sum total of these factor incomes [wages, rent, interest and
profits] at domestic level is termed as national income.
Aggregate
Supply = Output = National Income
Components of Aggregate supply:
For the sake of simplicity Keynes has regarded only two main
components of aggregate supply: Consumption and saving. A major portion of
income is spent on consumption of goods and services and remaining is saved.
Thus, national income (Y) or aggregate supply (AS) is sum of consumption (C)
and savings (S).
AS=Y=C+S
Aggregate Supply Schedule
|
Income [Y] In lakhs |
Consumption[C] In lakhs |
Saving [S] In lakhs |
AS= C+S In lakhs |
|
0 |
40 |
-40 |
0 |
|
100 |
120 |
-20 |
100 |
|
200 |
200 |
0 |
200 |
|
300 |
280 |
20 |
300 |
|
400 |
360 |
40 |
400 |
|
500 |
440 |
60 |
500 |
Aggregate supply curve will be 45° positively slope line from the origin.
Important point
about AS schedule and diagram
1.
Consumption
curve shows that there is autonomous consumption even when national income is
zero.
2.
Consumption
curve has a positive slope, which shows that consumption increases with the
increase in income but the proportionate increase in income is more than that
of consumption as after a certain level, a part of income is saved.
3.
When
income is equal to consumption, it is known as break-even point.
4.
When income is
less than consumption, the amount spent on consumption comes from Savings and
it is known as dissaving. when
income is more than consumption, a part of income goes in savings.
Dr. Swati Gupta
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