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
011
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