Aggregate Demand and Aggregate Supply

Aggregate Demand: It refers to the total value of final goods and services which all the sectors of an economy are planning to buy at a given level of income during a period of an accounting year. It is measured in the terms of total expenditure on goods and services of households, firms, government of the economy. Or we can say that it is aggregate expenditure on consumption and investment that all sectors of the economy are willing to incur at each income level. Thus, the term aggregate demand and aggregate expenditure are used interchangeably. It is a flow concept as it is generally measured for an accounting period. It refers to a planned expenditure and not the actual expenditure.

Aggregate Demand is denoted by AD.

According to Keynes, aggregate demand refers to the total amount of money, that the buyers are ready to spend on goods and services, produced in an economy during a given period.

Components of Aggregate Demand

1. Private (household) consumption expenditure

it refers to total expenditure incurred by households on purchase of goods and services during an accounting year. Consumption demand depends mainly on disposable income [the amount of money that a household has to spend or save after the deduction of income taxes is disposable income.] and propensity to consume. It is denoted by C.

2. Investment expenditure

it refers to the total expenditure incurred by all the private investors on capital goods like machines, plant, equipment, etc to increase the production capacity. It includes addition to the stock of physical capital assets. Investment’s demand depends upon marginal efficiency of capital and interest rate. It is denoted by I.

Investment is of two types, Autonomous Investment and Induced investment, but in Keynes theory investment is assumed to be Autonomous.

The basic difference between Induced Investment and Autonomous Investment:

  • Induced Investment: Induced investment is profit or income motivated. It is positively related with income. When income increases, consumption demand also increases, as a result, investment increases. Thus, induced investment is a function of income I = f(Y).

It is income elastic and increases or decreases with the rise or fall in income. Generally, it is done in a private sector.

  • Autonomous Investment: it is independent of the level of income that’s why it is income inelastic. It is influenced by exogenous factors like innovations, inventions, growth of population, social and legal institutions, revolution, etc. Such investment includes expenditure on building, dams, roads, canals, schools, hospitals, etc. Autonomous investment is regarded as public investment as it is generally done in government sector.

For simplicity, it is assumed that investment expenditure is autonomous and not influenced by the level of income.

3.Government expenditure

it refers to the total expenditure incurred by the government on consumption expenditure (such as education, health, transport, defence, law and order, etc) and investment expenditure (such as roads, infrastructure, power plants, etc.) to satisfy the common needs of the economy. It is denoted by G.

4. Net Exports

It refers to the difference between exports and imports. Exports indicate demand for goods produced within domestic territory of a country by rest of the world while imports indicate to the demand of the residents of a country for the goods that have been produced abroad. Net exports depend upon many things like Foreign Trade Policy, Foreign Exchange Rate, etc.

Net Exports= Exports- Imports (X-M)

Thus, Aggregate Demand = C+I+G+(X-M)

Aggregate demand in two sector model

In a two-sector economy [households and firms], we ignore government expenditure and net exports and include only consumption expenditure and investment expenditure that is AD=C+I.

Aggregate demand depends upon the level of income and there is a positive relation between income and aggregate demand in the economy.

Aggregate Demand Schedule

Income [Y]

In lakhs

Consumption[C]

In lakhs

Investment[I]

In lakhs

AD= C+I

In lakhs

0 40 40 80
100 120 40 160
200 200 40 240
300 280 40 320
400 360 40 400
500 440 40 480

Important points about aggregate demand schedule and diagram-

  • Aggregate demand is the total of consumption expenditure and investment expenditure AD=C+I
  • There is minimum level of consumption even if the income is zero. It is called autonomous consumption and is denoted by:
  • The slope of consumption curve is upwards from left to right because consumption increases with the increase in income.  Increase in consumption becomes less than increase in income after a certain point because people start saving as the level of income increase.
  • Investment expenditure is autonomous and is not influenced with income that’s why it is parallel to X-axis.
  • Aggregate demand curve has a positive slope which shows that aggregate demand increases with the increase in income.

Aggregate Supply

Aggregate supply refers to money value of final goods and services that the firms are willing to supply in an economy in an accounting period. It refers to the total production of goods and services in an economy. Aggregate supply of goods of an economy depends upon the stock of capital, the amount of labour used and the state of technology. In the short run, stock of capital and technology remains constant and therefore output can be increased by increasing the amount of labour employed. Thus, each level of employment involves certain money costs of production including normal profits which the entrepreneur must cover. The value of total output is distributed to the factors of production in the form of wages, rent, interest and profits. It represents the national income of a country during a period of time because the sum total of these factor incomes [wages, rent, interest and profits] at domestic level is termed as national income.

Aggregate Supply = Output = National Income

Components of Aggregate supply:

For the sake of simplicity Keynes has regarded only two main components of aggregate supply: Consumption and saving. A major portion of income is spent on consumption of goods and services and remaining is saved. Thus, national income (Y) or aggregate supply (AS) is sum of consumption (C) and savings (S).

AS=Y=C+S

Aggregate Supply Schedule

Income [Y]

In lakhs

Consumption[C]

In lakhs

Saving [S]

In lakhs

AS= C+S

In lakhs

0 40 -40 0
100 120 -20 100
200 200 0 200
300 280 20 300
400 360 40 400
500 440 60 500

Aggregate supply curve will be 45° positively slope line from the origin.

Important point about AS schedule and diagram

  1. Consumption curve shows that there is autonomous consumption even when national income is zero.
  2. Consumption curve has a positive slope, which shows that consumption increases with the increase in income but the proportionate increase in income is more than that of consumption as after a certain level, a part of income is saved.
  3. When income is equal to consumption, it is known as break-even point.
  4. When income is less than consumption, the amount spent on consumption comes from Savings and it is known as dissaving. when income is more than consumption, a part of income goes in savings.

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