 The sum of all expenditure in the economy over a period

of time
 Macro concept – WHOLE economy
 Formula:
AD = C+I+G+(X-M)
 C= Consumption Spending
 I = Investment Spending
 G = Government Spending
 (X-M) = difference between spending on imports and
receipts from exports (Balance of Payments)
 Shows the overall level of spending at different price
levels
 Note – Inflation used for the vertical axis – follows from
new thinking that Central Banks do not target the money
supply but short term interest rates
 Why does it slope down from left to right?
 Assume RBI sets short term interest rates
 Assume a rise in the price level will be met by a rise in
interest rates
 Any increase in interest rates will raise the cost of
borrowing:
 Consumption spending will fall
 Investment will fall
 International competitiveness will decrease – exports fall,
imports rise
 Therefore – a rise in the price level leads to lower levels of
aggregate demand
 The AD diagram:
 Inflation on the vertical axis – assume an initial
‘target rate’ of 2.0% (as measured by the WPI or
CPI)
 Real GDP or Real National Income or Real
Output on the vertical axis (shown by the initial
Y)
Inflation Thea lower
This
At higher
level oflevel
rate
output
of
of
At an
will be inflation
inflation
National associated
(3.0%)
Income level
of 2%,
with
rising
requires the
ainterest ADrates
particular
fewer units
curve
level
mean
of labour gives
ofthat– C,aIlevel
and
3.0% of output
(X-M)
unemployment of Y1 rises
all have
which
negative
to 7% we shown
effects
will by
callon
UU=
= 5%
AD
7% – NY falls to Y2

2.0%

AD

Y2 Y1
U = 5%
Real National Income
U = 7%
 This would
Shifts cause
in AD will be a
Inflation Any exogenous
rise in by
caused national
changes in
factor
factors causing
incomeaffecting
(economicC,C,
I,
IG or
andG(X-M)
growth) toand
rise,
leador
(exogenous
a factors)
to trade surplus
a fall in
e.g. increasing
causes a rates
unemployment
income tax shift (U
to
=
the2%)
affect (and
right in vice
consumptionAD
versa)

2.0%

AD2
AD

Y1 Y2
U = 5% U = 2%
Real National Income
 Exogenous factors affecting consumption:
 Tax rates
 Incomes – short term and expected income over lifetime
 Wage increases
 Credit
 Interest rates
 Wealth
 Property

 Shares

 Savings

 Bonds
 Spending on:
 Machinery
 Equipment
 Buildings
 Infrastructure
 Influenced by:
 Expected rates of return
 Interest rates
 Expectations of future sales
 Expectations of future inflation rates
 Defence
 Health
 Social Welfare
 Education
 Foreign Aid
 Regions
 Industry
 Law and Order
 Goods and services bought from abroad – represents an
outflow of funds from India (reduces AD)
 Goods and services sold abroad – represents a flow of
funds into India(raises AD)
 Government Income (taxes and borrowing)
 Government Spending
 Interest Rates (RBI)
 Costs of Production
 Technology
 Education and Training
 Incentives
 Tax regime
 Capital stock
 Productivity
 Labour Market
Inflation AS Between Y1 and Yf,
The
This
Yf shape in of
shape
Anrepresents
output
increases the
level AS
‘Full
of
capacity Y1
are
curve
wouldissuggest
Employment
possible important
but thein –
theOutput’
nearer
reflects
determining
the
at economy
economy
this point agets
is the to Yf,
working
Keynesian
the morefull
outcome
economy
below problems
in the view
iscapacity
workingare to
experienced
economy
full
andcapacity with
there wouldandacquiring
be
of the
resources
cannot
widespread
AS curve.
to boost
produce any
Economy starts to overheat production (production
more.
unemployment.
bottlenecks) especially
labour skills shortages.

Y1 Yf
Real National Income
Inflation
AS1 AS2
Increases in
capacity can
occur as a result
of a shift in AS
(akin to a shift
outwards of the
Production
Possibility
Frontier) (PPF)

Yf1 Yf2 Real National Income

Inflation SRAS assumes
Short run
costs suchsupply
aggregate as
overall assumes
(SRAS) wage
firms only able to
rate remain
increase output at
SRAS 1 fixed, changes
higher costs (e.g.
in such costs
overtime
cause a shift in
payments)
the SRAS
thereby curve
pushing
SRAS (exogenous
up price level
shocks – input
costs)
SRAS 2

Real National Income

Inflation LRAS This is because they
Classical
believe that in the
economists
long run, there will be
assume
no the long
unemployment of
resources because
run aggregate
markets will clear,
supply curvethe
thus whatever
(LRAS) is vertical
rate of inflation, firms
will supply the
(perfectly
maximum capacity of
inelastic).
the economy.

Yf Real National Income

Inflation AS
For our analysis,
we will assume
the AS curve
looks like this!

Real National Income

 A shift in the AD
AS In thisto
situation,
AD1 as athe
Inflation curve
economy
result of awould
changebein
operating
any or all ofat the
less
than
factorscapacity,
affectingthere
AD
would be
would increase
unemployment
growth, reduce and
the economy might
unemployment but at
be growing only
a cost of higher
slowly.
inflation (a trade-off)
2.5%

2.0%
AD 1

AD

Y1 Y2 Yf Real National Income

 Putting AD and AS together
Further increases in
AS
Inflation AD would lead to
successively
smaller increases in
growth and
employment at the
3.5% cost of ever higher
inflation.
AD2
2.5%

2.0%
AD1

AD
Yf
Y1 Y2 Y3 Real National Income
Inflation AS AS1
Sustained growth
(not to be
confused with
sustainable
economic
growth) occurs
when AS and AD
rise at similar
rates – national
income can rise
without effects
on inflation
2.0%

AD2
AD
Y1 Y2 Real National Income