1

Aggregate Demand and Aggregate Supply

As we know macroeconomic aim to attain full employment or target to optimum utilization of human
resources and other resources available in a country so In this concern macroeconomics have two tools as
aggregate demand and aggregate supply.
What is AD?
Aggregate demand is desired or planned expenditure on the purchase of domestically produce goods and
services by all sectors of the economy during an accounting year.
What is the component of AD?
AD = C + I + G + X – M (Desired / Planned)
‘C’ ⇒ Private final consumption expenditure
‘I’ ⇒ Investment expenditure (Private)
‘G’⇒ Government expenditure (consumption + Investment)
‘X – M’ ⇒ Net Exports
AD in two sector model
AD = C + I
‘C’ Privates final consumption expenditure: -It is also called household consumption expenditure.
➢ Consumption expenditure is depends on level of personal disposable income. Higher the PDI higher
will be the ‘C’ and lower the PDI will leads lower the ‘C’.
➢ Consumption expenditure never becomes zero even at zero PDI because household spend. Minimum
on consumption from their past saving or by the borrowing.
➢ Consumption expenditure at zero PDI is called autonomous consumption which is denoted by C or a .
➢ Consumption expenditure is depend on level of ‘Y’
Fundamental Psychological law of consumption given by J.M Keynes states that consumption
expenditure increase to the level of income but do not change in the same proportion as income changes.
‘I’ Investment Expenditure: -Private investment expenditure is the planned expenditure on making addition
to capital goods by private produces during a period of time.
Note:-For simplicity it is assumed in our study that investment expenditure is autonomous i.e. investment
decisions are not influenced by marginal Efficiency of investment, Rate of interest or any other determinant.
➢ Autonomous investment does not affected by any determinant thus its diagram draw horizontal to OX
axis
Aggregate Demand
Even through AD has four components, we win assume that AD is a function of only consumption
expenditure and investment expenditure i.e. AD = C + I

AD Schedule
Income (Y) Consumption (C) Investment (I) AD (C+ I)

0 40 40 80
100 120 40 160
200 200 40 40
300 280 40 320
400 360 40 400
500 440 40 480
600 520 40 560
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Y Y
Consumption expenditure Y AD = C + I

Investment expenditure
C
C

C + I = AD
I
B
I I
C
I I
X X I
O O Income
Income O X
Income
What is AS?
Aggregate supply means the value of final goods and services planned to be produced by all the production
units in the economy during an accounting year
What are the components of AS?
AS = C + S
Aggregate Supply = National Income
AS = Y
AS = Y = C + S
‘C’ consumption Expenditure
‘S’ Saving Expenditure
Consumption expenditure is expenditure by private sector final goods and services.
Saving Expenditure: - Saving as a component of Y may be negative when the level of Y is low. When C >
Y we draw from our past savings or we borrow from other. This is a situation of ‘-S’ which is equal to C
i.e. ‘ C ’ = -S’
AS Schedule
Income (Y) Consumption (C) Savings (S) AS = (C+ S)

0 40 -40 0
100 120 -20 100
200 200 0 200
300 280 20 300
400 360 40 400
500 440 60 500
600 520 80 600

Y Y
Y
C =Y(Break Even Point)
C
C >Y Y=C+S
S C<Y C
AS = C + S

S
C
) S
EP
C
ero (B
45o S =z +S
X O X O X
O Y Y
-S
-S
-Y
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Y = AS = 45o
As is perfectly elastic or it form 45o angle at origin it is because of the assumption that level of national
income (Y = AS) is equal to expenditure i.e. C + S.
Or
National income = National Expenditure
Y =C+S
Break-even point:- It is a situation when C = Y or S = zero. Consumption expenditure is equal to level of
income which means saving s zero.
Propensity Related to Income

Consumpion Savings

Average Marginal Average Marginal

C C C S
APC= MPC = APS = MPS =
Y Y Y Y
Average propensity of consumption (APC):- The average propensity to consume is the ratio of
consumption expenditure to any particular level of income
Y (Rs. Cr.) C (Rs. Cr.) APC (C/Y)

100 90 0.9
200 160 0.8

Y
APS = .9 C
160 APC = .8
90

O 100 200 X
Y
Marginal propensity to consume (MPC):-The marginal propensity to consume is the ratio of a change in
consumption to a change in income.
Y (Rs. Cr.) C (Rs. Cr.) APC (∆C/∆Y)

100 90 -
200 160 0.7
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Y C
MPC = .7
160
C
C 70
C 90 = = .7
Y 100
Y
O 100 200 X
Y
Average propensity to savings (APS):-The average propensity to save is the ratio of saving expenditure to
any particular level of income.
Y (Rs. Cr.) S (Rs. Cr.) APS (S/Y)

100 10 0.1
200 40 0.2

Y
APS = 0.1

S 40 APS = 0.2
10
O 100 200 X
Y

Marginal propensity to saving (MPS):- The marginal propensity to save is the ratio of a change in savings
to a change in income.
Y (Rs. Cr.) S (Rs. Cr.) MPS (∆S/∆Y)

100 10 -
200 40 0.3

S
S 40 MPS = = 0.3
S Y
10 Y
O 100 200 X
Y
−Y
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Relationship between Relationships between

APC & APS MPC & MPS
APC + APS = 1 MPC + MPS
C S C S
+ +
Y Y Y Y
C+S C + S
(Y = C + S ) (Y = C + S )
Y Y
Y  APC = 1 − APS  Y  MPC = 1 − MPS 
=1   =1  
Y  APS = 1 − APC  Y  MPS = 1 − MPC 

Saving Function: - It refers to the relationship between saving (S) and income (Y)
Algebraically S = −S + SY
Or
S = − S + MPSY
S =Saving -S = saving at zero income
C
MPS(S) = y = Income
Y

Consumption Function: - It refers to the relationship between consumption (C) and income (Y)
Algebraically C = C + by / C = a + by
Or
C = C + MPCY
C = Consumption, C = Consumption at zero ‘Y’
C
MPC (b) = Y = Income
Y
At zero Y C = −S
Full employment: -Full employment is a situation in which everyone who wants to work is working expect
for those who are frictionally and structurally unemployed.
Voluntary unemployment: - Voluntary unemployment refers to the situation when a person is unemployed
because he is not willing to work at the existing wage rate even when work is available.
Involuntary unemployment: -Involuntary unemployment is a situation in which people are able to work
and willing to work at existing rate of wages but do not get work.
Investment Function:- Investment refers to the expenditure incurred on creation of new assets. It includes
the expenditure incurred on assets like machinery, building, equipment, raw material ect.
Types of investment
(A) Induced Investment:- Induced investment refers to the investment which depends on the profit
expectations and is directly influenced by income level
(B) Autonomous Investment:- Autonomous investment refers to the investment which is not affected by
change in the level of income and is not induced solely by profit motive.
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A Y
Y B
I

Autonomous
Investment
1
I

Investment
Induced
I I I

I
X O Y X
O Y Y1 Y1
Income
Income
Determinants of Investment
According to Keynes’s the decision to invest in a new project by private sector depends upon two factors
(A) Marginal Efficiency of investment (MEI):- MEI refers to the expected rate of return from an additional
investment MEI is determined by two factors.
(i) Supply price: - It is the price at which the new capital assets can be supplied or replaced.
For example:- If a machine of Rs. 10,000 is replaced in placed of an old machine then Rs. 10,000
is the supply price
(ii) Prospective yield:- It refers to net return expected from the capital assets over its life time
For example:- If given machine is expected to yield receipts of Rs. 1200 and running expenses will
be Rs 200, then the prospective yield will be 1200 – 200 = Rs. 1000.
Prospective yield 1000
In the given example MEI will be MEI = 100  100 = 10%
Supply price 10, 000
(B) Rate of interest (ROT):- If refers to cost of borrowing money for investment. There is an inverse
relationship between ROT and volume of investment. At a high ROI the investment will be less and
vice-versa.
Note:-Comparison of MEI with ROI:- The profitability of an investment can be worked out by
comparing MEI with ROI. If MEI > ROI then investment is profit table, e.g. If a businessman has to pay
12% ROI and the MEI 20% then he will surely go for the investment and will continue making
investment till MEI = ROI.
Ex-ante saving:- Ex- ante saving is the amount of saving which household plans / Desired to save at
different level of income in the economy.
Ex-ante Investment:- Ex-ante investment is the amount of investment which firms plan / Desired to
invest at different level of income in the economy.
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Unit -7
Determination of Income / Output & Employment
Determination of Equilibrium level
According to J.M. Keynes theory of modern macroeconomics equilibrium condition is generally where AD
= AS during a period of time.
So, Equilibrium is when
AD = AS (i)
We know AD = C + I
Also AS = C + S
Thus AD = AS means
C+I=C+S
Where C is common
So as I = S (ii)
There are two approaches for determining the equilibrium level of income employment in the economy.
Approaches
1. AD = AS
2. I = S
Assumption for equilibrium determination
1. Closed Economy:- The equilibrium level of income and output is discussed with reference to a closed
economy. In such economy national income  domestic income.
2. As is perfectly elastic:- As rises according to AD till full employment level.
3. Technology constant:- Rate of technology to increase GDP is discard. Technology assume to be
constant.
Aggregate Demand Aggregate Supply approach
An economy will be in equilibrium where AD = AS Because in such a situation planned production is equal
to planned purchase in the economy. The producers do not suffer (A) The burden of unwonted supplies (or
unsold stock) (B) The loss of unfulfilled demand (due to lack of stocks) when AD = AS, value of actual stock
= Value of desired stock with the producers.
Investment and saving approach
According to saving investment approach Ex ante investment (Planned) is equal to Ex ante saving (Planned).
Whatever income flow out from the circular flow in form of savings again injected in the circular flow by
investment. This way circular flow of an economy completed in a financial year resulted value of actual stock
equal to value desired stock.
AD & AS or S & I Approach Schedule
Employme Income Consum Savings Invest AD AS AD & A&I
nt (Y) ption (S) (I) (C + (C + S) AS Status
(Crore) (C) I) Status
0 0 40 -40 40 80 0 AD > AS I > S

10 100 120 -20 40 160 100 AD > AS I>S

20 200 200 0 40 240 200 AD > AS I>S

Break Even Point

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30 300 280 20 40 320 300 AD > AS I>S

40 400 360 40 40 400 400 AD = AS I=S

Equilibrium

50 500 440 60 40 480 500 AD < AS I<S

60 600 520 80 40 560 600 AD < AS I<S

AD & AS Approach of Equilibrium

Y AS ( Y ) = C + S
AD < AS AD = C + I

600 AD =AS

500
AD & AS

400
AD >AS
300

200

100

45o
O 100 200 300 400 500 600 X
Y S & I Approach of Equilibrium
80
70
I<S
60
50 I=S
S&I

40 I
30
20
I>S
10
0
100 200 300 400 500 600 X
−10
Y
−20
−30
-S −40

-Y

When AD is more than AS

When planned expenditure on goods and services (AD) is more than planned production or factor income
(AS). It means that consumers and firm together would be buying more goods than firms are willing to produce
AS a result. The planned inventory would fall below the actual stock. Which further leads increase in the price
level?
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When AD is less than AS

When planned expenditure on goods and services is less than planned production or factor income distributed
during a financial year. As a result the planned inventory would rise so an economy faces unwanted stock, to
clear the unwanted stock producers cut in the investment which further decrease the employment and national
income.
When Saving is more than Investment
If planned savings are more than planned investment. It means that households are not consuming as much as
the firms expected them. As a result actual stock would rise than desired stock which further leads cut in
investment and ultimately decline employment and national income.
When Saving is less than Investment
It planned savings are less than planned investment. It means that households are consuming more and saving
less than what the firms are expected to them. As a result actual stock would be less than desired stock which
further leads to increase in prices.
Equilibrium Level
According to classical economist equilibrium level of income is always achieved at the full employment level
but according to Keynesian theory equilibrium level can be achieved at the full level under employment level.
Full Employment Equilibrium
Full employment equilibrium refers to a situation when the AD is equal to AS at full employment level. It
means all those who are willing to work at the prevailing wage rate are able to find employment so full
employment means absence of involuntary unemployment.
Over Full Employment Equilibrium
Over full employment equilibrium refers to a situation when AD is equal to AS beyond the full employment
level. We know output cannot increase beyond the full employment level so this will increase the general price
level.
Y Full
Under empolyment AS
ADE
empolyment Over full
G
empolyment
ADF
N E ADU
AD / AS

S
U
T

O L Q P X
Income / Output / Employment

Effective Aggregate Demand

Effective AD is refers to that level of AD which become effective because it is equal to the AS.
Investment multiplier is the ratio of increase in national income due to an increase in investment.
It is denoted by ‘K’.
Y
K=
I
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Suppose an additional investment (∆I) of Rs 100 corer in an economy generates an additional income (∆ Y
of Rs 400 Corers. The value of multiplier (k) will be
Y 400
K= , =4
I 100
K=4
Working of Multiplier
Initial investment bring change in national income which further leads change consumption expenditure and
this change in consumption expenditure again bring change in income and this process continue throughout
the financial year
Change in ⎯⎯ → Change in ⎯⎯ → Change in ⎯⎯ → Change in ⎯⎯ →
investment Income Consumption Income
I ⎯⎯
→Y ⎯⎯
→C ⎯⎯
→Y ⎯⎯ →C
Multipler (K)

Y 1  MPS = 1 − MPC
K= K=
1 K=
I 1 − MPC MPS
1 1
Prove that K = or K =
1- MPC MPS
Y
We know that K =
I
Also know that Y = C + I (at equilibrium)
So as ∆Y = ∆C + ∆I ⎯⎯ → ∆I = ∆Y - ∆C
Putting the value ∆I
Y Y
K= K = Divide RHS of equation by ∆Y
I Y − C
Y
K= Y K=
1
or K =
1
(Because 1 – MPC = MPS)
Y C 1 − MPC MPS
−
Y Y
Forward Action and Backward Action of Multiplier
Forward Action:- When there is a multiple increase in income caused by an increase in investment.
Backward Action:- When there is a multiple decrease in income caused by an decrease in investment
Relation of Investment Multiplier with MPC & MPS
K with MPC:- K and MPC both have positive relationship i.e. any increase in MPC also leads to increase in
K and vice versa
MPC↑ K↑
MPC↓ K↓

K with MPS:- K and MPS both have inverse relationship i.e. any increase in MPS also leads to decrease in
K and vice versa.
 MPS  K 
 
 MPS  K 
Facts
1. Only APS can be a negative value among alt.
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2. MPS cannot be negative because saving and income have positive relation.
3. K never become zero its value always various between 1 & ∞(infinity) So minimum value of K
= 1 Maximum ∞.
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Unit -8
Excess Demand- Deficient Demand & Correction of it
Excess Demand
Excess demand refers to the situation when aggregate demand is more than the aggregate supply
corresponding demand to full employment level in the economy.
Excess AD = AD > AS (at full employment)
Inflationary Gap
Inflationary gap refers to the gap by which actual AD exceed the AD required to established full employment
equilibrium.
Inflationary Gap = AD at Actual level
(-) AD at full employment level
Y
AS (Y)
Infalionary
AD (at actual level)
Gap F
AD (at full employment)
AD & AS

45o
O X
Y / O / Emp.
Causes of excess AD or Inflationary gap
AD  C  I  G  X  M  or Tax 
C↑ Private final consumption expenditure is rising
I↑ Investment expenditure is rising.
G↑ Government final consumption expenditure rising
X↑ Export rising thus AD is exceeding
M↑ Import declining thus domestic demand giving rise in AD.
T↓ Taxes are low hence a price is low and further leads to rise in AD.
Consequences / Impact of Excess AD & Inflationary gap
1. Because AD > As producer faces decline in the actual stock than the planned by the producer.
2. All the producer tend to increase in the prices of goods and services
3. Due to this general price level continuously rise, which is known as inflation.
4. And Inflation create problem for wages earner because their wages become insufficient to buy basic
requirement of life and thus they demand more wages from their employers.
5. When employers (producer) pay more wages then before it resulted increase in cost of output and to cover
this increase cast producers again increase the prices and this wages price spiral push an economy
in inflation.
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Deficient Demand
Deficient demand refers to the situation when AD is less than AS corresponding to full employment level in
the economy.
Deficient AD = AD < AS (at full employment)

Deflationary Gap
Deflationary gap is the gap by which actual AD falls short of AD required to establish full employment
equilibrium.
Deflationary gap = AD required to full employment
(-) AD at Actual level
Y
AS (Y)
AD (at full employment)
E
AD & AS

AD (at actual level)

F Deflationary
Gap
45o
O X
Y / O / Emp.
Causes of Deficient Demand or Deflationary gap
AD  C  I  G  X  M  or Tax 
C↓ Private final consumption declining
I↓ Investment expenditure declining
G↓ Government expenditure falling
X↓ Fall in the Export
M↓ Rise in the Import
T↑ Taxes are high thus AD is less
Consequences / Impact of Deficient AD & Deflationary gap
1. Because AD < AS producer faces is in eh actual stock than planned by the producer.
2. It will force to producer to plan for less investment in the coming year.
3. Which affect as less output and fall in the employment level
4. Employment fall leads to decline in national income and again AD fall.
Differences between Excess Demand & Deficient Demand
Basis Excess Demand Deficient Demand

Meaning It refers to the situation when It refers to the situation when

AD is more than AS AD is less than AS
corresponding to full corresponding to full
employment level in the employment level in the
economy economy.
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Inflationary or Deflationary Gap It leads to Inflationary Gap It leads to Deflationary Gap

Equilibrium level It indicates over full It indicates under employment

employment equilibrium. equilibrium.

Reason It occurs due to excess of It occurs due to shortage of

anticipated expenditure, i.e. due anticipated expenditure, i.e. due
to rise in consumption to fall in consumption
expenditure, investment expenditure, investment
expenditure, etc. expenditure, etc.

Impact on output and It does not affect the output and It leads to fall in output and
Employment employment as economy is employment due to shortage of
already operating at full aggregate demand.
employment level.
Impact on price It leads to inflation, i.e. it results It leads to deflation, i.e. it results
in rise in general price level. in fall in general price level.

Measures to Control Excess and Deficient Demand

There are two policies to control inflationary and deflationary gap
(1) Monetary policy adopted by central bank
(2) Fiscal policy adopted by government.
Measures to Correct Excess Demand /Inflation
1. Fiscal Policy:- Fiscal policy is policy related with government revenue and expenditure. It is announce
in budget thus it is as known as budgetary policy.
A. Government Expenditure:- Government reduce budget expenditure to control excess demand this way
flow of money reduces from government side which resulted less public income and hence AD start
shrinking.
B. Government Receipts:-
(i) Tax: - By increasing the tax burden on the household and the producers the government reduces
purchasing power in the economy.
(ii) Public Borrowing: - When there is a situation of excess demand the government steps up public
borrowing by altering attractive rate of interest. This reduces liquidity with the people accordingly
AD also reduces.
C. Deficit Financing: - Deficit financing when government ask RBI to issue new currency but in situation
of excess AD deficit financing avoided.
2. Monetary Policy:- Monetary policy is the policy which adopted by central bank by regulating interest
rate and availability of credit in the economy. Interest rate is cost of credit.
A. Bank Rate:- Bank rate is the rate at which the central bank lends money to commercial banks. To correct
the situation of excess demand bank rate is increased. As a follow up action the commercial banks raise
the market rate of interest. This reduces demand for credit which further affect consumption and
investment expenditure.
B. Cash Reserve Ratio (CRR):- CRR is the cash required to maintain with central bank by the commercial
bank from its deposits. CRR is raised o correct situation of excess demand. This reduces their capacity to
create credit.
C. Statutory Liquidity Ratio (SLR):- The commercial bank required maintaining minimum cash at its
branches against demand deposits.
 15

At the time of excess demand rate of SLR increased by central bank which further affect credit availability
and also AD.
D. Open market operation:- It is the policy that focuses on increasing and decreasing the stock of liquidity
with the people through sale and purchase of securities by the central bank.
During the excesses demand time central bank sale its investment or reserve in the open market which
further reduces cash with the commercial band and further reduces credit availability and AD.
E. Margin Requirement:- Margin requirement refers to difference between the market value of security
offered and the value of amount lent. At the time of excess demand margin requirement increases by
central bank so borrower find it less attractive to borrow money and it decreases the level of AD.
F. Selective Credit Control:- It refers to a method in which the central bank gives directions to other banks
to give or not give credit for certain purposes to particular sectors. During excess demand the central bank
introduces rationing of credit in order to prevent excessive flow of credit.
Measures to correct Deficient Demand / Deflation
1. Fiscal Policy:-
A. Increase in government expenditure to give rise in people’s income which leads AD further.
B. Decreases in government receipts
(i) Taxes are reduced to increase purchasing power.
(ii) Government reduces public borrowing so that people left with more cash which leads to rise in AD.
C. Deficit Financing: - Government borrows from central bank thus central bank allowed to issue more
currency which increase flow of money and further leads to rise in AD.
2. Monetary Policy:-
A. Central bank reduces bank rate hence cheap loan available for commercial bank so as their lending also
cheap.
B. CRR & SLR:- Central bank reduce the CRR & SLR by which more cash balance left with commercial
bank and it leads to increase in credit flow.
C. In open market operation central bank buy securities and investment of commercial bank to increase the
cash balance with commercial bank hence credit flow give rise to AD.
D. Margin requirement reduces to increase the borrowing capacity of the public.
Some Important
➢ Wage price spiral:- It is a situation when wages catch the price and prices catch the wages and
ultimately result in inflation
➢ Cheap money policy:- It is a monetary policy adopted by central bank in which central bank reduce
the cost of credit and easy availability of credit. It adopted in deficient demand or deflationary gap.
➢ Dear money policy:- It is monetary policy adopted by central bank at the time of excess demand or
inflation time. In this cast of credit rises by central bank and credit policy become more ridged than
before.

******