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Aggregate Demand & Aggregate Supply

Overall output of the economy fluctuates over time. These fluctuations bring hardship to citizens of
the economy because it has implications on their employment, income, and purchasing power. Study
of aggregate demand (AD), aggregate supply (AS) is to understand the sources of these fluctuations,
and to find ways to reduce these fluctuations.
AD and AS are macroeconomics concepts and different from the demand and supply you have
already studied in microeconomics.

Understanding Aggregate Demand (Y):


Aggregate demand is the total demand of the economy, and total amount of spending done in the form
of consumption, investment, government expenditure, and net-exports.
Y=C+I+G+NX

----- (1)

This demand is different from the concept of demand you have studied in microeconomics. Figure 4
shows the differences. Let us spend some time to understand these differences.

In both the cases the curve is downward sloping; however the reason for their downward slope is
different.
In microeconomics the demand is measured for a specific product or services. If the price falls then
the consumer may find the marginal utility from the product to be higher and decides to spend the
money. Similarly, if price falls the consumer may substitute the cheaper product with the expensive
product.
In case of macroeconomics the AD curve is downward sloping for 3 different reasons.
First, due to the wealth effect because consumers feel wealthy when the general price level falls (all
other things remaining same). Imagine, your salary has not changed and price level has fallen. In case
that happens all of us will end up spending more money, hence more output.

Second, due to increase in saving the interest rate will fall (will discuss this in detail later in the
course), and hence investment demand will rise, which will result in more output. Due to increase in
savings the savers will get more interest income and consume, which will result in more output.
Third, due to fall in interest rate, the currency will depreciate (will discuss this in detail later in the
course), hence price of the exported goods and services will fall. This fall in prices will result in
increase in export, and will result in higher aggregate demand.

Shifts in Aggregate Demand


We saw that total spending declines when price level rises (holding other things constant). When
these other things change, there can be shift in AD upwards and downwards depending on the
direction of changes. This is shown in the figure 5.

What are those other things that can change the AD? Some of the important things that can change
the AD are;

Government Policy
o Personal income tax: Reduction in tax will have more
more consumption for each price level.
o Tax rebate for investment: Reduction in tax will
investment.
o Spending programs of government: If government
aggregate out will shift outwards.
New Industry: Emergence of new industry will increase
consumption demand.
Innovation:

disposable income, and hence


result in more demand for
decides to spend more the
the investment demand and

o
o

Innovation will result in creation of newer products and services resulting in shift in
aggregate demand.
Innovation will result in increase in productivity of labour, and hence the income
level. Increase in income level will result in shift in aggregate demand.

Understanding Aggregate Supply:


If we take a position that, the producers will respond to the demand, then AD and AS will be equal.
Response time of producers to the change in AD will decide how AS reacts. Therefore, AS is different
in the short-run from the long-run. This is shown in figure 6.

In the short-run, the producers will respond positively to increase in prices (all other things remaining
the same) by producing more. This can happen because of two broad reasons.
First, the producer may perceive the general change in prices as micro changes in prices of their
respective goods and services. As all the producers react by increasing the production level there will
be increase in output.
Second, in the short-run, the wages (by contract), price of inputs (by contract) may be sticky. This
sticky wages and costs will result in increase in profit of producers when they come across rising
prices. In pursue of higher profit the producers will increase the output in the short-run.
As time passes by, the producers will experience increases in costs, and wages that will wipe out
additional profit. In the long-run the producers will not increase the production in response to change
in prices, and AS will be independent of general price level, and the AS will be at the Y*, the natural
level of output. Natural level of output is not the maximum level of output. It is the output that the
country will able to produce naturally without stretching the factors of production (labours will work
8 hours, not 24 hours, factory will not operate more than 100%). Therefore, AS is depend on the time
frame of our considerations.

As discussed for AD, AS in the long-run can also shift if other things changes, which is shown in
figure 6. The shift in AS can shift due to change in populations, technological changes, increases in
productivity of labour forces, and any other external events like war.

Understanding the Keynesian Multiplier Model


Fundamental of macroeconomics is to understand the mechanism by which changes in spending get
translated into changes in aggregate output, employment, and prices. The simplest approach to this
understanding is the Keynesian multiplier model. According to this model, a unit of exogenous
change in spending will result into a multiple unit of change in aggregate output. The model is
graphically shown in figure 7. For simplicity we have assumed that the economy does not trade with
external world.

In the figure 7, the 450 line represents the equilibrium of the economy. Along the line the expenditure
(Z) is always equal to GDP (Y). Initially equilibrium occurred at E where Y=Z as shown in Z line.
The C0 is the autonomous consumption as discussed in Keynesian consumption function. If the
government decides to spend [C0 C0] amount there will be change in total expenditure, which will
translate into increase in GDP as shown in Z line. As shown in the graph change in autonomous
consumption of [C0 C0] will result in [Y Y] change in GDP. We can observe that;
[Y Y] >>> [C0 C0]
A small change in autonomous expenditure results into larger change in GDP.

Estimating the Multiplier


Let us do this in simple mathematical model as well, and quantify the change in GDP. Let us for the
time being assume that we are considering a closed economy. It means that the NX component is zero
and the GDP (Y) is;
Total expenditure is divided into 3 parts, the consumption (C), investment (I), and government
expenditure (G).
(

G is the government expenditure


By all the three component of expenditure we can estimate the total expenditure as;
(

In equilibrium the total expenditure will be equal to the GDP of the economy.
(

The equation can be rewritten as;


, and by rearranging we can get
(

If we divide both sides by (1-c) we will get;


(

--------------- (2)

In equation 2 there are two components. The component


hence can be called the autonomous spending.

is independent of Y,

Exercise:
Is this component positive? When will this be negative?
The other component is related to marginal propensity to consume (c). Given that c is between 0 and
1, the component

will be greater than one. In equation 2, this component is multiplied with the

autonomous spending, and is called the multiplier. Higher the value of c, higher will be the multiplier.
The multiplier effect in the economy will make sure; any changes in autonomous expenditure will
result in increase in GDP, which is more than the autonomous expenditure.
Let us say the government decide to spend 100crs more, and the MPC is 0.6. What will be the change
is GDP?
The multiplier here is [1/ (1 - 0.60] = 2.5.
Therefore, the change in GDP will be 250crs.

An Alternative way to look at Equilibrium


In last section we looked at the equilibrium in goods and services market from demand (expenditure)
and supply (production) prospective. The same equilibrium can be seen when saving is equal to
investment. We can argue that the economy will be at equilibrium when saving of the economy is
equal to investment in the economy.
Let us understand this with help of simple mathematics.
( )

------- (3)

When T G > 0 government is having surplus budget, and when T G < 0, government is having
deficit budget.
For a closed economy
Y=C+I+G
By subtracting T from both sides we will get,
YT=C+I+GT
By rearranging the same we will get,
YTC=I+GT
Putting the value of saving from equation 3, we will get
S=I+GT
By rearranging we can get,
I = S + T G -------------------------------(4)
In this case S is household saving and T G is government saving.
Therefore, investment is equal to household saving and government saving, and the equilibrium will
occur when equation 4 holds.

Re-Estimating the Multiplier


We can estimate the multiplier from this as well. By using the Keynesian consumption function we
can write the equation 1 as
(

We can rewrite this as


(

)(

) --------- (5)

In equilibrium the saving will be equal to investment. We can rewrite the equation 4, by putting the
value of S as shown in equation 5.

)(

)
(

By rearranging we will get


(

This can be rewritten as


(

--------------- (6)

The equation 6 is nothing but what has been shown in equation 2. Therefore, we can also estimate the
multiplier when saving is equals to investment.

What is the source of this multiplier?


The increase in autonomous demand will increase production. The increase in production will result
in increase in income equal to increase in production. The subsequent increase in income will result in
more consumption, and hence more demand. The incremental demand will lead to increase in more
production and will result in increase in income. This process will continue till the point, whole
multiplier effect is achieved.