Aggregate Demand, Aggregate Supply and Related Concepts
1. Aggregate Demand (AD)
Aggregate Demand (AD) is the total planned expenditure on all final goods and services in an
economy during a given period.
Components of AD:
o Consumption Expenditure (C): Expenditure by households on goods and
services.
o Investment Expenditure (I): Expenditure by firms on capital goods.
o Government Expenditure (G): Expenditure by the government on consumption
and investment goods.
o Net Exports (X-M): The difference between exports (X) and imports (M).
AD in a Two-Sector Economy: In a simple closed economy without a government, AD is the
sum of consumption and investment.
o Formula: AD = C + I
2. Aggregate Supply (AS)
Aggregate Supply (AS) is the total value of all final goods and services that producers are willing
to supply in an economy during a given period. It is conceptually equivalent to the national
income (Y).
AS Curve: In the Keynesian framework, the AS curve is represented by a 45-degree line from
the origin. This signifies that AS is perfectly elastic up to the full employment level, meaning
producers are willing to supply whatever is demanded at a constant price level.
Identity: AS = Y (National Income)
3. Consumption Function
The consumption function describes the relationship between consumption (C) and income (Y).
Keynesian Psychological Law of Consumption: As income increases, consumption also
increases, but by a smaller amount.
Equation of the Consumption Function:
C = C̅ + bY
o C: Total consumption expenditure.
o C̅ : Autonomous Consumption – The minimum level of consumption even when
income is zero. It represents consumption financed by past savings or borrowing.
o b: Marginal Propensity to Consume (MPC).
o Y: Level of national income.
Marginal Propensity to Consume (MPC): The ratio of the change in consumption to the
change in income. It shows the proportion of additional income that is consumed.
o Formula: MPC (b) = ΔC / ΔY
Average Propensity to Consume (APC): The ratio of total consumption to total income.
o Formula: APC = C / Y
4. Saving Function
The saving function describes the relationship between saving (S) and income (Y).
Equation of the Saving Function:
S = -C̅ + (1-b)Y
o S: Total saving.
o -C̅ : Autonomous Saving (or dis-saving) – The amount of saving when income is
zero. It is the negative of autonomous consumption.
o (1-b): Marginal Propensity to Save (MPS).
o Y: Level of national income.
Marginal Propensity to Save (MPS): The ratio of the change in saving to the change in
income. It shows the proportion of additional income that is saved.
o Formula: MPS (1-b) = ΔS / ΔY
Average Propensity to Save (APS): The ratio of total saving to total income.
o Formula: APS = S / Y
5. Relationship between Propensities
● APC + APS = 1
● MPC + MPS = 1
Short Run Equilibrium Output
1. Determination of Equilibrium
Equilibrium is achieved when planned aggregate demand equals planned aggregate supply.
There are two approaches to determine this:
AD-AS Approach: Equilibrium occurs where AD = AS. Since AS = Y, the equilibrium
condition is Y = C + I. At this point, the total planned spending in the economy equals the total
planned output.
Saving-Investment (S-I) Approach: Equilibrium occurs where planned saving equals planned
investment (S = I). This is a derivative of the AD-AS approach.
o We know Y = C + I (Equilibrium condition)
o We also know Y = C + S (Income identity)
o Therefore, C + I = C + S, which simplifies to I = S.
2. Investment Multiplier
The investment multiplier measures the extent to which a change in investment leads to a change
in national income. It shows that an initial increase in investment results in a larger final increase
in income.
Mechanism: An increase in investment leads to an increase in income. This increased income is
partly consumed (based on MPC), which becomes income for others. This process continues in
successive rounds, with each round's increase in income getting smaller, until the total increase
in income is a multiple of the initial investment.
Multiplier Formulae:
K = ΔY / Δ I
K = 1 / 1 - MPC
K = 1 / MPS
o K: Investment Multiplier.
o ΔY: Change in Income.
o ΔI: Change in Investment.
Relationship: The value of the multiplier is directly related to MPC (a higher MPC means a
larger multiplier) and inversely related to MPS (a higher MPS means a smaller multiplier).
Problem of Deficient Demand and Excess Demand
1. Deficient Demand (Deflationary Gap)
Deficient demand occurs when aggregate demand is less than the aggregate supply
corresponding to the full employment level of output.
Deflationary Gap: The gap by which actual aggregate demand falls short of the aggregate
demand required to establish full employment equilibrium.
Consequences:
o Underemployment Equilibrium: The economy gets stuck in an equilibrium with
involuntary unemployment.
o Fall in Output and Employment: Firms reduce production and lay off workers
due to lack of demand.
o Deflationary Pressure: The general price level tends to fall.
2. Excess Demand (Inflationary Gap)
Excess demand occurs when aggregate demand is greater than the aggregate supply
corresponding to the full employment level of output.
Inflationary Gap: The gap by which actual aggregate demand exceeds the aggregate demand
required to establish full employment equilibrium.
Consequences:
o Inflation: Since output cannot increase beyond the full employment level, the
excess demand leads to a continuous rise in the general price level.
o Wage-Price Spiral: Higher prices reduce real wages, leading to demands for
higher nominal wages, which increases production costs and pushes prices up
further.
o No Change in Real Output: Real GDP remains fixed at the full employment
level; only nominal GDP increases due to rising prices.
3. Measures to Correct Deficient and Excess Demand
The government and the central bank use fiscal and monetary policies to manage AD.
Policy To Correct Deficient Demand To Correct Excess Demand
(Increase AD) (Decrease AD)
Fiscal Policy
Government Spending Increase government Decrease government
expenditure. expenditure.
Taxes Decrease taxes to increase Increase taxes to reduce
disposable income. disposable income.
Monetary Policy
Bank Rate Decrease the bank rate. Increase the bank rate.
Repo Rate Decrease the repo rate. Increase the repo rate.
Reverse Repo Rate Decrease the reverse repo Increase the reverse repo
rate. rate.
Open Market Buy government securities. Sell government securities.
Operations
Cash Reserve Ratio Decrease CRR. Increase CRR.
(CRR)
Statutory Liquidity Decrease SLR. Increase SLR.
Ratio (SLR)
Margin Requirements Decrease margin Increase margin
requirements on loans. requirements on loans.
Suggested Questions
1. Explain the components of Aggregate Demand in a four-sector open economy.
2. Using the equation of the saving function, explain the concept of autonomous saving
(dis-saving). Why is it negative?
3. If MPC is 0.75, what is the value of the investment multiplier? If investment increases
by ₹1,000 crore, what will be the total increase in national income?
4. Explain the determination of equilibrium income and output using the Saving-
Investment (S-I) approach. Use a diagram.
5. What is a deflationary gap? Explain its impact on the economy's output, employment,
and price level.
6. Distinguish between voluntary and involuntary unemployment. Can an economy be in
equilibrium when there is involuntary unemployment?
7. What is an inflationary gap? Explain the role of Open Market Operations in correcting
it.
8. How does a change in government spending work as a tool of fiscal policy to correct
both deficient and excess demand?
9. Explain the mechanism of the investment multiplier with the help of a numerical
example.
10. Given the consumption function C = 100 + 0.8Y, find the equilibrium level of income
if planned investment is ₹500.