Aggregate Demand | Short Run | Equilibrium | Chapter 7 & 8 | Class XII |

Aggregate Demand | Short Run | Equilibrium | Chapter 7 & 8 | Class XII |

Aggregate Demand (AD)

Aggregate demand refers to the total demand of all goods and services in an economy during an accounting year. It is measured in the terms of aggregate expenditure on ex-ante (planned). All goods and services that people are willing to incur at different income level is known as Aggregate Demand.

AD Schedule: AD schedule is the tabular representation of the sum total of expenditure that people are willing to spend on the goods and services at different income level during an accounting year.

AD Schedule

Income (Y) AD
0 20
10 25
20 30
30 35
40 40
50 45

 

AD Curve: AD curve refers to the diagrammatic representation of the demand by the people on different goods and services in an economy during an accounting year corresponding to the different level of income.

Components of Aggregate Demand

The components of AD are discussed in two references namely, components of AD in a closed economy and components of AD in an open economy. 

 

Components of AD in a closed economy: The closed economy is further divided into 2 parts that are two sector economy and three sector economy.

  • Under two sector economy, there are two types of expenditure; first one is the expenditure done by the households which is called household consumption expenditure. In economics, it is represented by the alphabet C whereas the expenditure done by the producer sector for a longer period of time is called Private Investment Expenditure and represented by (I).

To calculate AD in two sector economy, both the expenditure done by household and producer are added together to get the value of AD.

AD = C + I

  • Under three sector economy, the expenditure done by the government in the form of welfare for consumption as well as for the investment purpose both are taken, which is represented by the alphabet G along with the expenditure done by the households sector in the form of consumption expenditure and the expenditure done by producer sector in the form of investment are taken all together to calculate the value of AD of that economy during an accounting year.

AD = C + I + G

Components of AD in an open economy: In the open economy, the expenditure of four sectors are taken together to get the value of AD.

The four sectors along with their expenditure are as follows:

  • Consumption expenditure done by household which is represented by the alphabet C
  • Private Investment Expenditure done by the producer sector which is represented by the alphabet I
  • Expenditure of Government in both the forms consumption as well as investment which is represented by the alphabet G
  • Expenditure done by the rest of the world. It is calculated by the value of net exports which is the difference between the value of export of goods and the value of import of goods of an economy.

AD = C + I + G +(X-M)

You May Also Read

1. Macroeconomic; Scope and Significance, Micro Vs. Macroeconomics

2.      Basic Concepts of Macroeconomics

3.      National Income, GDP and Welfare

4.      Calculation of National Income| Methods and Steps |

5.      Barter System-Limitations | Money | Forms | Measurement |

6.      Commercial Banks | Credit Creation | Central Bank Functions|

7.      Aggregate Demand |Short Run | Equilibrium |

8.      Excess Demand | Deficient Demand |

9.      Government Budget | Objectives | Types |

10.    Foreign Exchange | Rate | Demand and Supply |

11.    Balance of Payment | Structure | Deficit | Types |

Aggregate Supply (AS)

Aggregate supply refers to the total planned supply that a producer is willing to make or willing to produce in an accounting year. While giving the concept of Aggregate Supply (AS), Keynes made an assumption that the economy which he chose is a closed capitalist economy due to which the net factor income from abroad (NFIA) is calculated to 0.

In other words, aggregate supply is the sum total of cost which is produced within a country or can be said that it is the value of Net National Product at Factor Cost (NNPFC).

AS = (Wages) + (Rent + Interest + Profit)

= (Compensation of employees) + (Operating Surplus)

= NDPFC (Net Domestic Product at Factor Cost)

= NNPFC (Net National Product at Factor Cost)

= C (consumption) + S (saving)

 

AS Schedule: AS Schedule refers to the tabular representation of the flow of goods and Services which is planned by the producer in an economy during an accounting year.

AS Schedule

Income AS
10 10
20 20
30 30
40 40
50 50

AS Curve: AS curve refers to the diagrammatic representation of the flow of goods and Services which is planned by the producer in an economy during an accounting year.

Consumption Function (Propensity to Consume)

Consumption function refers to the functional relationship between the income and aggregate consumption. In other words, it reveals the expenditure done by the households with respect to the different level of income in an economy.

As per Keynes, consumption is directly related to the income which means that with the increase in income, the consumption expenditure increases or vice versa but the rate of increase in consumption is smaller than the increase in income and Break-even point is achieved but the producer continues to produce to earn profit. Break-even point refers to the point where the savings is 0 (zero) and whole income is spent on consumption. In other words, it refers to the point where the level of income is just equal to the level of consumption. Above the level of break-even, income is greater than consumption whereas below that level consumption is greater than income.

C = C (bar) + MPC.Y

Schedule and Curve

Income (Y) Consumption (C) Savings (S)
2000 2600 -600
3000 3300 -300
4000 4000 0
5000 4700 300
6000 5400 600

Conclusion

  1. With the increase in income, consumption also increases and vice versa.
  2. When C > Y, saving is negative.
  3. When C = Y, saving is zero also called beak-even point.
  4. Income can be zero but consumption can never be.

The Propensity to Consume is of two types:

  • Average Propensity to Consume (APC): It refers to the ratio of aggregate consumption expenditure to aggregate income. In other words, it shows the percentage of income (y) which is spent on the consumption (c).

APC = Consumption (C) / Income (Y)

Schedule and Curve

Income (Y) Consumption (C) APC
0 8
10 16 1.6
20 24 1.2
30 32 1.06
40 40 1
50 48 0.96

Conclusion

  1. When APC is more than one, consumption is more than income.
  2. When APC is equal to one, consumption is equal to the income.
  3. When APC is less than one, income is more than consumption.

 

  • Marginal Propensity to Consume (MPC): It refers to the ratio of change in consumption to change in income. It shows the total change in the level of consumption with the change in the level of income in an economy.

MPC = Change in Consumption(C) / change in Income (Y)

Points to remember:

  • If the entire additional income is consumed, the value of MPC is 1.
  • If the entire additional income is saved, then the value of MPC is 0 (zero).

Saving Function (Propensity to Save)

Saving function refers to the functional relationship between the income and aggregate saving. In other words, it reveals the total saving done by the households with respect to the different level of income in an economy. It is that part of income which is not consumed and by deducting the total consumption from total income, saving can be calculated.

S = Y – C

The saving function is derived from consumption function,

C = C(bar) + MPC.Y

And we know that,

Y = C + S     or    S = Y – C

Therefore,

S = Y – [C(bar) + MPC.Y]

Y – C – MPC.Y = -C(bar) + Y – MPC.Y

S = -C(bar) + (1 – MPC)Y

S = -C(bar) + MPS.Y

Schedule and Curve

Income (Y) Consumption (C) Saving (S)
0 200 -200
100 250 -150
200 300 -100
300 350 -50
400 400 0
500 450 50

 

The Propensity to Save is also of two types:

  • Average Propensity to Save (APS): It refers to the ratio of aggregate saving to aggregate income. In other words, it shows the percentage of income (y) which is saved (S).
Income (Y) Saving (S) APS
100 40 0.4

Points to remember

  1. APS can never be 1 or more than 1
  2. APS can be 0
  3. It rises with the rise in income.

 

  • Marginal Propensity to Save (MPS): It refers to the ratio of change in saving to change in income. It shows the total change in the level of savings with the change in the level of income in an economy.

Point to remember

  1. MPS Varies from 0 to 1.

Relationship between Propensity to Consume and to Save

  • The relation between APC and APS is always 1.

APC + APS = 1

  • The relation between MPC and MPS is always 1.

MPC + MPS = 1

Short Run

Short run refers to a period under which technology remains to be constant or plays no role in determining the level of output in an economy. The output is determined with the level of employment in an economy that means the higher the level of employment implies the higher level of output and vice versa. There is a proportionate relationship between employment and output. Therefore, the rate of employment increases with the increase in the rate of output.

In the words of J.M. Keynes “A period of time during which level of output is determined exclusively by the level of employment in the economy, is termed as short-run.”

Equilibrium Output

It is calculated in two ways, which are:

  1. AS, AD Approach

This approach is also known as Equilibrium Income, Equilibrium Gross Domestic Product (GDP) or Equilibrium Output. Under this, the point of equilibrium is the point where aggregate demand of an economy is equal to the aggregate supply in an economy. In other words, the sum total of expenditure that all the buyers are likely to do in an economy is equal to the total output that a producer is willing to produce or supply.

Under this, Keynes considered AD as principal for determining the equilibrium income as AS is perfectly elastic owing to the excess capacity in an economy which means equilibrium can only be shifted with the increase or decrease in the total expenditure done by the buyer because at the time of depression in an economy, the level of AD is less due to which the production remains unutilized and when the period of depression gets over and there is increase in the level of AD and the level of AS increase to fulfill the requirements of the people.

AD = AS

Or

Y = AD

Y = AD in relation with Income

Income (Y) Consumption (C) Investment (I) AD = C + I
0 10 10 20
10 15 10 25
20 20 10 30
30 25 10 35
40 30 10 40
50 35 10 45

 

Two situations are studied along with this.

When AS is more than AD: Under this situation, the aggregate supply is more than the aggregate demand in an economy due to which producer is left with the stock which is unsold. Therefore, to clear that stock, the producer cuts the level of production from high to low so that the level of production can match with the level of demand by the buyers in an economy.

When AS is less than AD: Under this situation, the aggregate supply is less than the aggregate demand in an economy due to which the stock with producer is sold out and the producer suffers a loss for he fails to fulfill the demand. Therefore the producer plans higher level of production so that the demand of the market can be met.

  1. S, I Approach

Under this, the point of equilibrium is the point where investment in an economy is equal to the level of saving in an economy. In other words, the sum of investment done by the producer in an economy is equal to the total saving by the household sector of an economy.

The equation of this approach is derived from the equation of equilibrium output

AS = AD

It can also be written as

C + S = C + I

Now, by taking C common from both side, we get the equation

S = I

S = I in relation with Income

Income Consumption (C) Saving (S) AS = C + S
10 15 -5 10
20 20 0 20
30 25 5 30
40 30 10 40
50 35 15 50

 

The saving and investment can further be classified as, ex-ante and ex-post. The further clarification is as follows:

  • Ex-anti Saving: This type of saving can also be called as desired saving or planned saving for a period of one year. It refers to the level which is planned by the people to save in an economy for a period of one year.
  • Ex-post Saving: It can also be called as actual saving. It refers to the amount which is actually saved by the people of a country in an economy for a period of one year. It is helpful in calculation of national income.
  • Ex-anti Investment: It refers to the level of investment which is desired or planned by the producer in an economy for a period of one year, therefore it can also be called as desired investment or planned investment but it does not include unplanned investment.
  • Ex-post Investment: It refers to the level of investment which is actually done by the producer in an economy during a period of one year. It is also known as actual investment. It includes both planned and unplanned investment.

This approach is also studied with two situations which are;

When S is more than I: It refers to a situation where people tend to save more than to invest. In other words, it is a situation in which the more expenditure falls due to the rise in saving than the investment. Therefore, the producer is left with unwanted stock. To handle this situation, the producer now produces lesser output so that the saving can be equal to the investment.

When S is less than I: It refers to a situation where people tend to save less than to invest. In other words, it is a situation in which the more expenditure falls due to the fall in saving than the investment. Therefore, the producer has a surplus stock left and he suffers a loss due to not meeting the demand. To handle this situation, the producer produces more output so that the saving can be equal to the investment.

Multipliers and Process

Investment Multiplier: It is also known as output multiplier and refers to the situation wherein ‘Number of times by which the increase in output is exceeded by the increase in investment’. In other words, it refers to the total increase or decrease in the level of output due to increase or decrease in investment respectively.

K = change in Output/Income / Change in Investment

Relation of Multiplier (K) with Marginal Propensity to Consume (MPC): The relation of K with MPC is a proportionate relationship, which means with the increase in the value of MPC, the value of K also increase and with the fall in the value of MPC, the value of K also decreases.

K = 1 / (1-MPC)

Derivation

Multiplier process:

  1. With the change in the level of Investment, the producer will have a greater capital to invest and can produce more output.
  2. As the level of output is increased, the producer can sell more output and with the selling of more output the producer can earn more.
  3. To increase the production, producer hires more labour and make them work more so that they can also earn more.
  4. With the change in the level of income, there is a change in the level of consumption as people have more money due to which they spend more for the consumption.
  5. This process goes on as they spend money on the consumption which increases the income level of another person and the consumption level of that person also increases.

 

Do share this post if you liked the notes of Aggregate Demand. For more updates, subscribe to our website BrainyLads

Add a Comment

Your email address will not be published. Required fields are marked *

error: Content is protected !!