Aggregate Demand

Aggregate Demand (AD) refers to

the total amount that different
sectors in the economy willingly
spend in a given period.
It is the sum of spending by
consumers, businesses and
Governments.
Aggregate Demand
Ad has four components or spending
streams:
1. Consumption (C)
2. Investment ( I )
3. Government purchases (G )
4. Net exports (X)
The sum of the spending streams at
any price level is the aggregate
spending or AD at that price level.
Consumption

• This is primarily determined by

the disposable income.
• Other factors are – long term
trends in income, household
wealth and aggregate price
level.
Investment
• Investment spending includes
purchases of buildings, softwares,
equipments and accumulation of
inventories.
• Major determinants of Investment
are the level of output, cost of
capital and expectations about the
future.
• Monetary policy can affect
Investment
Government Purchases

• This covers purchases of goods

like tanks or road building
equipment as well as services
of Judges, school teachers.
• This is dependent directly on
the spending decisions by the
Governments.
Net Exports

• This equals value of exports

minus value of imports.
• Imports and exports are
determined by respective
incomes and outputs, relative
prices and foreign exchange
rates of the country and foreign
countries.
Aggregate Supply

• Aggregate supply (AS) refers to

the total quantity of goods and
services that the nation’s
businesses willingly produce
and sell in a given period.
• AS depends upon the price
level, the economy’s productive
capacity and the levels of costs
Aggregate Supply

• The AS curve is the schedule

showing the level of total national
output that will be produced at each
price level.
Aggregate Supply fundamentally
depends upon two sets of variables:
• Potential Output and
• Input costs
Potential Output &
impact on AS
• Inputs – supplies of capital,
labor and land are important
inputs. Potential output comes
when unemployment of labor
and other resources is at non
inflationary levels. Growth of
inputs increases potential
output and aggregate supply.
• Technology and efficiency –
innovation, technological
improvements and increased efficiency
increase the level of potential output
and raise aggregate supply.
Costs and Impact on AS

• Wages – lower wages lead to

lower production costs; lower
costs mean higher quantity
supplied at every price level for
a given potential output
• Potential output is the maximum
sustainable output that can be
produced without triggering rising
inflationary pressures.
• Potential output is a growing target-
as the economy grows it also
increases and AS curve shift to the
right.
Keynesian Theory

According to Keynesian Theory,

the Equilibrium level of national
income is determined where
aggregate Demand (AD) equals
Aggregate Supply (AS).
AD schedule is also called C + I
schedule. C= a +bY
Keynesian Theory
Employment

• Classical economic theory rests on

the assumption of full employment of
labour and other resources within an
economy. Normal situation in any
economy is the stable equilibrium at
full employment. Full employment is
a situation when there is no
involuntary unemployment.
Employment
• If we look at the population, there
are those who are not in the labour
force – too young to work < 14, too
old >65, physically and mentally
handicapped and those in the prison.
• Then there are those who do not
want to work, those unwilling to
work at existing wages voluntary
unemployment.
• Rest form the Labour force
Unemployment

• Unemployment refers to as a
percentage of the labour force.
• Frictional unemployment is caused
on account of immobility of labour,
seasonal nature of work, temporary
shortage of inputs like raw
materials, breakdown of machinery,
ignorance about job opportunities
etc.
Unemployment

• Technological unemployment is
the result of changes in the
techniques of production –
machines replacing men.
• Seasonal unemployment arises
in a particular industry due to
seasonal variation in activities
or customary nature.
unemployment

• Structural unemployment is said

to exist when a large no of
persons are unemployed not
because they want to remain
idle but because the co-operant
factors of production to engage
them fully are not sufficiently
available.
• Keynes put unemployment in 3
categories:
1. Frictional
2. Voluntary
3. Involuntary
Frictional unemployment caused by
inexactnesses standing in the way
of continuous full employment.
• Voluntary
unemploymentresulted from the
refusal of the worker on
account of collective bargaining
or other such reasons to accept
reward corresponding to his
marginal productivit.y
• Involuntary unemployment resulted
from the deficiency of effective
demand because are unemployed
persons who would be willing to
work at less than the existing real
wages.
• At full fulle employment level of
economic activity there could be
frictional or voluntary unemployment
but not involuntary unemployment.
• Keynes while agreeing that Fr,tech and str
unemployment can coexist with full
employment , he did not agree with
classical economists that there is always
full employment in the economy; what
exists is actually < full employment. Full
employment is a situation beyond which an
increase in effective demand cannot raise
output or employment. Once full
employment is attained any further
increase in effective demand cannot
increase output and demand can only be
inflationary.
Effective Demand
• Total employment depends on total
demand and unemployment is the result of
deficiency in total demand.

• Total demand is divided into consumption

demand and investment demand.

• As employment increases income

increeases.A fundamental principle is that
as real income increases,consumption will
also increase but by less than the income.
Effective Demand
• Therefore, in order to have enough
demand to sustain an increase in
employment, there must be an
increase in real investment – equal
to the gap between income and the
consumption demand out of that
income.
• Employment can not increase unless
investment increeases.
• This is the core of the principle of
Effective demand.
Effective Demand

• Total demand in the economy

consists of consumption goods and
investment goods (the former is the
major portion).
• TD goes on increasing with increase
in income and employment.
• At various levels of income there are
corresponding levels of demand but
not all levels are “effective”
Effective demand

• Only that level of demand is

effective which is fully met with
corresponding supply – so that
entrepreneurs neither have a
tendency to reduce nor expand
production.
• Effective demand is that level of
demand that is in equilibrium with
(equal to) the supply in the economy.
• According to Keynes, it is how much
people intend to spend that determines the
level of consumption and investment. The
intensions to spend are translated into
aggregate demand.
• Should aggregate demand fall below what
the business expect to receive, there will
be cut backs resulting in unemployment. If
aggregate demand exceed expectation
production will be stimulated and
employment increases.
Effective Demand
• In any economy effective demand
represents the money actually spent on
products of industry. Money received by
entrepreneurs is paid out in the form of
wages, rent, interest and profit. As such
effective demand (actual expenditure)
equals national income- the receipts of all
members of the community.It also
represents the national output – total price
of national output.
• Effective Demand=NI=Value of national
output = Expenditure on C and I
..Effective Demand

• In the above analysis we

considered expenditures on
Private consumption and private
investment. In modern
economies Govt. expenditure
and foreign trade have become
an important determinants of
Effective demand.
 Aggregate demand thus is made up of:
• Private consumption expenditure (C )
• Private investment expenditure (I)
3. Public investment expenditure (G)
4. Foreign expenditure on domestic goods & services over &
above domestic exp on foreign goods and services (X-M)
Y= E=C+I+G+(X_M)=ED
Amount of saving and Taxes should be equal to Investment
expenditure plus Govt. expenditure
I+G+X= S+ T+M
• Therefore in order to maintain
effective demand at original
level, real investment ,equal to
the gap b/w income and
consumption must be made.
Thus employment can not
expand unless investment
expands.
Importance of E D
• The concept of eff demand has established
beyond doubt that whatever is produced is
not automatically consumed nor is income
spent at a rate which will keep the factors
of production fully employed.
• As employment increases income also
increases leading to a rise in consumption
but less than the rise in income. Thus
consumption lags behind and causes the
gap between total income and total
expenditure.
Determinants of E D
• Effective Demand relates ,at any given
level of employment, to the expected
proceeds from the volume of employment.
The expected proceeds depend on
expected expenditures on C and I. Every
producer in free enterprise economy tries
to max his proceeds. Sum total of income
payments made to factors of production is
his factor costs. Thus factor costs +
entrepreneur’s profits gives the total
income or proceeds resulting from a
particular level of employment.
Determinants of ED
• Entrepreneurs make decisions about
the amount of employment they offer
to labour on the basis of
expectations of of proceeds –
estimates of total money they
receive by sale of goods and
services at various levels of
employment. Enterprises push
employment of labour at which
effective demand will give them
maximum proceeds.
Aggregate Demand
function
• A schedule of the proceeds
expected from the sale of
output resulting from varying
amount of employment is called
the Agg Demand Schedule or AD
Function-an increase function of
the amount of employment.
• D= f (N)
Agg Supply Function

• There are some proceeds of output

which the entrepreneurs expect will
just make it worthwhile to provide
certain amount of employment.
• There are minimum expected
proceeds which are considered
necessary to induce entrepreneurs
to provide certain amount of
employment.
Agg supply function

• A schedule of the minimum amount

of proceeds required to induce
entrepreneurs to give varying
amounts of employment is called the
Aggregate Supply Schedule.
• This is also an increasing function
of the amount of employment.
• In Aggregate Demand function it is the
expected sale proceeds which is
considered ,while in the Aggregate Supply
schedule it is the minimum sale proceeds
necessary.
• There will be difference between them
because at certain level of employments
(outputs) producers will expect more
proceeds than the minimum sale proceeds.
• S= phy(N)
• AS F slopes upward from left to right and
goes on increasing with increase in output
and employment.
Determination of Level
of Employment
• OY – Proceeds OX - employment
• DD is Aggregate Demand Function
and SS the Aggregate Supply
Schedule.
• The Point of Equilibrium (E) where
the ADF (DD) is cut by ASF curve SS
(St. Line) is called the Point of
Effective Demand.
• (Fig 16 page 177 )
Employment level

• At any point to the left of E, ASF

lies below ADF, so that at OM
level of employment the
expected sale proceeds MM’ >
the minimum sale proceeds
necessary. The portion MT
shows that employers will be
induced to produce more
employment.
Eqbm Level Employment

• At OK level of employment KK’

level of expected minimum
proceeds expected sale
proceeds are only OK. Most of
the entrepreneurs will be
disappointed and therefore
reduce employment.
Employment reduces till ON, the
Equilibrium Employment level
• At E, entrepreneurs do not have
a tendency either to increase or
to decrease employment.
• This may not be the full
employment equilibrium.
Consumption Function

• Classical theory – level of cons and

investment depends on int rates. As
int rate increases, cons decreases
and investment increases.
• Keynesian argument – consumption
is relatively unaffected by int rates.
• (Marginal propensity to consume is
positive and APC declines as income
rises.)
Psychological Law of
consumption
• The fundamental psychological law,
upon which we depend with great
confidence, from our knowledge of
human nature and facts of
experience, is that men are disposed
to increase their consumption as
their income increases but not as
much as the increase in their
income.
• This is basically called ‘Propensity to
consume’
Propositions of the law
1. When aggregate income increases,
consumption expenditure will also
increase but by a somewhat lesser
amount’
2. Increment of income will be divided
in some ratio b/w saving and
spending.
3. Increase in income is less likely to
lead either to less spending or less
saving than before.
The consumption
Function
• The consumption function shows the
relationship between level of
consumption expenditure and the
level of disposable income.
• Y=C+S
• When Consumption equals
disposable income (45Degree line),
savings =0 -- the Zero saving line.
Consumption Function
In any economy, C= f (Y)
At various levels of income there will be
corresponding levels of consumption.
A schedule of the consumer expenditure
at various levels of income will result in
a schedule of propensity to consume.
(p 189, fig 17)
Marginal Propensity to
Consume
• This denotes the ratio of small
change in consumption as a
result of a small change in
income.
• This ratio is always less than
unity.
Determinants of
Consumption Function
• Subjective factors
• Objective factors
• Subjective – Psychological characteristics of
human nature promote saving– precaution,
foresight, family affection, old age security,
improvement, pride, enterprise. Motives that
induce consumption are enjoyment, better std
of lvng, recreation, generosity, extravagance,
ostentations etc
• Objective factors which cause
changes in the nature, slope and
position of the consumption curve
are:
• Income
• Distribution of income
• Financial policies(dividend) of Copns
• Fiscal policy of govt
• Windfall gains and losses
• Demographic factors
• Expectations
• Credit facilities
• Wealth & stock of money
• Rate of interest
Measures to Raise
propensity to consume
• Income redistribution
• Social security measures
• Long term Wage policy
The Saving Function
• Saving is defined as the difference
between disposable income and
consumption.
• S=Y–C
• Level of saving depends on the level
of income.
• The relation b/w saving and income
is called the propensity to save or
the saving function. S=f (Y)
Marginal Propensity to
save
• Income of the society is divided
between savings and spending. If
spending is known its counterpart
saving can easily be derived by
subtracting it from income.
MPC + MPS =1
• MPC = 1 - MPS
Average Propensity to
Save
• APS is the ratio of savings to
Income.
• APS = S/Y
Average Propensity to
consume
• This is the ratio of absolute
consumption to absolute
income C/Y or Aggregate
Consumption to aggregate
income.
• At any level APC can be found
by dividing the Consumption by
income
• Consumption at zero level income is
positive because instead of starving at
zero income the consumers draw on past
savings, borrow or sell property etc to buy
consumer goods. The consumption curve
therefore cuts the vertical axis at some
point. The consumption curve cuts the
Zero saving Y=C 45 degree line. Beyond
this point, income rises faster than
consumption and the curve flattens.
• ( Fig 21, page 192 Keynesian Economics)
APC and MPC

• As income increases both APC

and MPC decline. The decline in
MPC > APC.
• When MPC is constant the
consumption function is linear.
• APC because it does not pass
through the origin, is not linear.
APC and MPC

• Some times MPC and APC may

be equal.
• MPC is higher in the case of
poor communities and lower in
the case of rich communities
becaue in the former most of
the primary needs remain
unfulfilled.
Multiplier
• Employment depends on effective
demand which in turn depends on
consumption and investment
(Y=C+I).
• Consumption function is stable in
the short run and MPC < 1. Therefore
all the increases in income do not go
to increase cons to the extent of
increase in income. The gap b/w
income (output) produced and
consumed must be made up of inv.
…Multiplier

• Keynes believed that initial

increase in investment
increases final income by many
times. The relationship between
the initial increase in
investment and the final
increase in aggregate income is
the Investment or Income
multiplier.
Multiplier
• Multiplier is the ratio of the final
change in income to the initial
change in investment.
• K = Change in Income / change in
investment. i.e., K=dY / dI
• Y= C + I, dY= dC+dI,dI=dY-dC (i) but,
• dI=dY/ K.(ii) dY/K= dY-dC
• Dividing by dY ,1/K= 1- dC/dY
• K=1/ 1-dC/dY =1/(1-MPC) =1/MPS
Multiplier

MPC MPS K
0 1 1
0.5 0.5 2
0.75 0.25 4
0.8 0.2 5
0.9 0.1 10
1 0 infinity
Multiplier

• An initial investment of Rs 20
crores will result in final
increase income by 40 crores if
the multiplier is 2. But this does
not happen instantaneously but
happens over a period of time
after a series of smaller
expansions
Multiplier

• Of the 20 crore investment, at

first 10 crores will go towards
increasing consumption
(income) as MPC=0.5
• Next round addition to income
will be 5 cores ,then 2.5 crores
and 1.25 cr and so on…adding
up to 40 crores. (fig 27 p 232)
Limitations and
qualifications of Multiplier
• Availability of consumer goods for
increased consumption & income
• Need for maintenance of investment at
regular intervals
• Full employment ceiling- multiplier not
effective beyond full employment
• Availability of other resources in
underdeveloped economies
Investment
• Buying shares, bonds etc is not real
investment but transfer of existing
assets. Financial investment does
not affect aggregate spending.
• By investment is meant an addition
to capital- building a new house,
factory. Investment adds to stock of
goods existing .
Capital
• Capital refers to real assets like
factories, plants, equipment and
inventories of finished and semi-
finished goods.
• It refers to any previously produced
input that can be used in the
production process to produce other
goods. Capital is a stock concept –
capital in the economy is the stock
of capital in the economy.
• Investment is production or
acquisition of real capital
assets during any period of
time.
• It = Kt – Kt-1
Types of Investment

• Induced investment and Autonomous

investment.
• Induced investment -investment that
is income or profit motivated. Factor
prices, which affect profits influence
investment. Similarly demand also
influences investment. I=f (Y)
Induced investment is income elastic.
Autonomous Investment
• Autonomous investment –is independent
of level of income. It is influenced by
exogenous factors like innovations,
inventions, population growth, social
and legal institutions, wars, revolutions
etc. Investments in economic and social
field, whether made by government or
by private enterprise are autonomous
-Buildings, dams, schools, hospitals etc
• Gross investment – depreciation and
obsolescence allowance = Net
investment.
• Ig= In + Ir
• When Ig >Ir, In is positive leads to
increase in capital
• When Ig=In, industry is just maing
good the loss in capacity on account
of depreciation and obsolescence.
• Net investment may also include
expenditure on new consumer
durable goods and new capital
goods (stock of plant &
equipment held by business). If
economy is to grow the capital
stock must increase.
Determinants of
Investment
• The decision to invest in a new
capital equipment depends on
whether the expected return on
the new investment is = or > or <
interest rate to be paid on funds
needed to purchase the asset.
Invest if > interest.
 Three factors are involved:
1. The cost of capital asset
2. Expected return over life time
of the asset
3. Market rate of interest
Marginal Efficiency of
Capital
• Marginal Efficiency of Capital refers
to an anticipated rate of profitability
of a new capital asset.
• It is the ratio of between the
prospective yield of additional capital
goods and their supply price
MEC
• It depends on the expected rates of return of
capital assets over its life time and the supply
price of the capital asset.
• Businessmen will always weighthe expected
rates of net return (profitability) over the life time
of the asset (machine) against the supply price
(Cost) or the replacement cost
• MEC equals the unique the rate
of discount which would make
the present value of the series
of annuities given by the returns
expected from the capital asset
during its life just equal to its
supply price
• Sp=Vp = R1/(1+i) + …+Rn/(1+i)n
MEC

• Sp = 12,000 , i=5%
• R1= 1050,R2=3525 ,R3= 9260
• Vp= 1000 +3200+8000 =12200
Vp=or>Sp Invest
• Sp =9000 i=5%
• R1=3000,R2=3000, R3=3000
• Vp=8175 Vp<Sp Invest ?
Other Factors affecting
Investment
• Element of unertainty
• Existing stock of capital goods
• Level of income
• Consumer demand
• Liquid assets
• Inventions and innovations
• New products
• Population growth
• Stae policy
• Politicl climate
Inflation

• Inflation refers to a general and

sustained rise in the level of
prices of goods and services.
• Prices of vast majority of goods
and services on sale to
consumers keep on rising and
rising.
Inflation
• It is difficult to have a commonly accepted
definition of inflation.
Different defns:

• Inflation is a state in which the value of

money is falling
• Inflation exists when money income is
expanding more in proportion to income
earning activity.
• Exists when the amount of money exceeds
the value of goods & services
inflation

• When too much money chases too few

goods
• A state of disequilibrium in which an
expansion of purchasing power tends
to cause or is the effect of an increase
in the price level.
• According to Keynes inflation is caused
by an excess of effective demand.
Inflation
The sustained price rise may be of
different magnitude. Diff name
given to inflation depending on the
rate of rise in prices:
• Creeping inflation (< 3%)
• Walking or trotting (3-6 %)
• Running (10 to 20%)
• Runaway or galloping or
Hyperinflation (20 to 100% or more)
( Fig 1 page 838 J&S)
Inflation
• Semi inflation and true inflation-
According to Keynes so long as there are
unemployed resources, the general rice level
will not rise as output increases. But a large
increase in aggregate expenditure will face
shortages of non-substitutable supplies.
This may lead to increase in costs and prices
start rising (Bottlenecks). This may continue
till the level of full employment is reached.
This inflation is called semi inflation,
reflation or bottleneck inflation where
increased spending leads to increases in
employment.
Inflation

• Once the full employment is

reached increases in quantity of
money or expenditure will result
in True inflation sets in.
• Fig 85 page 574 Keynesian
Economics
Stagflation

• Stagflation is a paradoxical
phenomenon when the economy
experiences recession as well as
inflation.
• This happens when there is
excessive demand in the
commodities market causing the
prices to rise while demand for labor
is deficient ,creating unemployment.
Demand pull inflation

• Demand pull or excess demand

inflation is a situation often
described as too much money
chasing too few goods.
• Quantity theory of money states
that prices rise in proportion to
increases in money supply.
• ( Fig 3, Page 842 J&S)
• The assumptions are that the
economy is in full employment
and aggregate supply is fixed.
Cost push inflation

• This is caused by wage

increases enforced by unions
and profit increases by
employers.
• Though this is not a new
phenomenon, till 1950s the
thinking did not take place in
this direction.
Causes of inflation
1. Rise in wages
2. Sectotial rise in prices
3. Rise in prices of imported raw materials
4. Profit push – oligopploistic &
monopolistic firms try to enforce
administered prices
Inflationary Gap

• “Inflationary Gap is the amount by

which aggregate expenditure would
exceed aggregate output at full
employment level of income.”
• The larger the aggregate
expenditure, the larger the gap and
the more rapid the inflation.
• (Fig 5, page 845 J&S )
 Inflationary gap can be
reduced by:
• Increasing the savings so that
aggregate demand is reduced.
• Increase the taxes and rducing
expenditure by the Govt.
Inflationary Gap