Aggregate demand and Its Component
Aggregate demand (AD) refers to the total money value of final goods and services which all the sectors of the economy is Planning to buy at a given level of income during a period of one accounting year
Aggreate demand can be also defined as the total expenditure that different sectors of n economy are willing to make at a given income level during a given time period.
Components of Aggregate, Demand or Aggregate expenditure
Consumption Demand (C), Investment Demand (I), Government’s demand for goods are services (G), Net demand by foreigners i.e., net exports (X-M).
Thus, AD=C+I+G+X — M
- Private final consumption expenditure
It is the total expenditure that all households in an economy are willing to incur on the purchase of goods and services for their personal consumption in a given period of time.
Consumption is determined by several factors including the price of the commodities, income levels, price of related products, tastes and preferences; etc. The most important determinant of private consumption demand is the disposable income of the household.
- Investment Demand (Q )
The desired demand for capital goods by private investors during a given period of time. It means that addition to the capital stock or the expenditure incurred for the creation of new capital assets of a country (such as buildings, plant machinery). Investment includes fixed capital, change in stock of raw materials, finished and semi-finished goods and residential construction.
- Government Demand (G)
The total expenditure incurred by government on consumer goods and capital goods to satisfy the common needs of the economy.
It means, government incurs consumption expenditure as well as investment expenditure. Consumption expenditure is incurred in order to meet public needs like law and order„ education, health, transport and defense etc.
Investment expenditures involve construction of highways, roads, power plants etc.
- Net Demand by Foreigners (X – M)
Net demand by foreigners is the demand by the rest of the world for the goods and services of an economy in a given period time.
Net exports are the difference between a country’s exports and imports.
There are various factors affecting NET EXPORT
a. Forex rate
b. Govt policy
c. Relationship btw countries
Aggregate Demand in a Two-sector Model (AD = C+ I)
Since the determination of income and employment is to be studied in the context of two-sector model (households and firms), the third and fourth components of aggregate demand are not discussed in detail.
Consumption Function
The consumption function, also called the propensity to consume, is the desire or willingness of households to purchase goods and services at a given level of income in a given time period.
It is also termed as private consumption demand. C= f (y)
- The consumption function is based on Keynes famous ‘Psychological Law of consumption’.
This law states that as income increase, consumption also increase but less proportionately than the rise in income. In other words, as income increases consumption increases but does not increase by Rs.20 crores, then the increase in income.
Under a linear consumption function the rate of change of consumption is held constant.
C=c+bY Where,
C is the total consumption C is the autonomous consumption by is the induced consumption; b is the marginal propensity to consume.
- Positive consumption when income level is zero.
When income is zero, consumption takes place in an economy.
A positive level of consumption at zero level of income reflects that people need certain basic goods and services to sustain themselves, irrespective of income levels.
This consumption is termed as autonomous consumption as it is independent of the level of income.
Consumption that is dependent on the level of income is called induced consumption.
- Break-even point, from the table we also notice that when income is equal to Rs.200 crores, consumption is also equal to Rs.200 crores.
This income level is termed as the breakeven income. Breakeven point is the income where consumption equals to income.
Consumption Curve
A consumption curve is a diagrammatic representation of the relationship between income and consumption levels.
The important points to note regarding the consumption curve in figure are:
1. The consumption curve starts from a positive point on the y-axis, implying that there is consumption even when income level is zero.
2. The consumption curve slopes upwards, reflecting the direct relationship between income and consumption.
3. Since the slope of the curve is constant we get a straight-line consumption curve.
4. Point B is the break-even point where consumption is equal to income. In other words, households consume the entire income.
5. At income levels less than Rs.200 crores (break-even level of income), consumption is greater than income. Therefore, this additional expenditure is met through dissaving.
6. At income levels greater than Rs.200 crores, consumption is less than income. Here, the economy saves the unconsumed income.
Types of Propensities to consume
- Average Propensity to consume (APC)
- Marginal Propensity to consume (MPC).
Average Propensity to consume (APC)
Average propensity to consume refers to the ratio of consumption expenditure to the corresponding level of income.
APC is calculated by dividing the total consumption expenditure by total income.
APC = Consumption (C) /Income (Y)
Special Points about APC
1. The value of APC is more than 1. as long as consumption is more than national income, i.e., APC > 1 before the break-even point.
2. APC is equal to 1 when consumption is equal to national income, (Rs.200 crores) i.e., APC = 1 at the break-even point.
3. The value of APC is less than 1 when consumption is less than national income, i.e., APC>1 beyond the break-even point.
4. APC can never be equal to zero as consumption can never be zero at any level of income.
Graphically, APC represents any one point on the consumption curve. Point A, on consumption curve CC measures APC at the income level of OYI.
APC at point A =ON / oY 1
5. As income increases, APC falls continuously. However, APC can never be equal to zero since
onsumption is never equal to zero for any income levels.
Marginal Propensity to Consume (MPC)
Marginal propensity to consumer refers to the ratio of change in consumption expenditure ( A to change in total income ( Change Y)
symbolically: MPC =Change in consumption / Change in income
Special Points about MPC
Value of MPC varies between 0 and 1, Incremental income is either spent on consumption or aved for future use.
If the entire additional income is consumed, then change in consumption s equal to the change in income, making MPC = 1.
However, if the entire additional income is aved, then the change in consumption is zero.
In such a case, MPC = 0.
Saving Function Propensity to Save
Saving refers to the excess of income over consumption expenditure. Symbolically, S = Y — C
Saving function refers to the functional relationship between saving and national income. propensity to save shows the different levels of savings at different levels of income in an economy. S = f (Y)
Where, S = Savings; Y = National Income; f = Functional relationship.
The relationship between saving and income is illustrated in tables.
(i) Before the break-even point, savings are negative dis-savings of Rs.40 crores and Rs.20 crores.
(ii) At the break-even point, savings are zero (PointC), corresponding to the icome of Rs. 200 crores.
(iii) After the break-even point, savings are positive.
Propensities to save is of two types
1. Average Propensity to Save (APS)
2. Marginal Propensity to save (MPS)
Average Propensity to save (APS)
Average propensity to save refers to the ratio savings to the corresponding level of income.
Symbolically, APS = Saving (s) / Income (Y)
1. As the income increase, APS also rise
2. APS = 0 at the break-even point (as the entire income is consumed).
3. At income levels which lower than the break-even point, APS is negative, i.e., there are in thedissaving in the economy
4. At income level which are higher than the break-even point, AS has a positive value.
Marginal Propensity to Consume ( MPS )
Marginal Propensity to Consume save refers to the ratio of change in savings (AS) to change in total total income
MPS = change in savings / change in total total income
1. MI =1 if the entire additional income is saved (in such a case, change in savings will be equal to the change in income.
2. MI A it the entire additional income is consumed (Here, change in savings will be zero )
Relation Between APC and APS
The sum of APC and APS is equal to one. It can be proved as under. National income (A) = Consumption (C) + Savings (S)
i.e. Y = S + C
1 = APC APS
APC = 1 -APS
APS = 1 — APC
Linear Consumption Function
the function is expressed as follows C = r + b(Y)
Linear Saving Functions
As the consumption function is linear, the saving function is also linear.
The formula for saving function can be derived from that of the consumption function.
We know: S = Y — C
And C + by
Putting the value of C from (2) in (1), we get
S = Y(c +by)
S=Y—E. +Y—bY
S – + Y(1 — b)
Investment Function
Investment refers to the expenditure incurred on creation of new capital assets.
It includes the expenditure incurred on assets like machinery, building, equipment, raw material etc.
The investment expenditure is classified under two heads:
(i) Induced Investment;
(ii) Autonomous Investment.
Induced Investment
The induced investment which depends on the profit expectations and is directly influenced by income level. Induced investment is income elastic.
Autonomous Investment
The investment which is not affected by changes in the level of income and is not induced solely by the profit motive.
| Induced Investments | Autonomous Investment |
| Induced Investments is driven by profit motive. It depends upon the profit expectations of the entrepreneurs. | Autonomous investments are done for public and social welfare, not profit. |
| An increase in the level of income raises the level of induced investment and vice-versa. In other words, its curve slopes upwards as it is income elastic. | Autonomous investment is unaffected by changes in the level of income. In other words, it is income inelastic and its graph is parallel to the X-axis. |
| Induced investment is generally done by the private sector. | Autonomous investment is generally done by the government sector. |
| Besides income, induced investment also depends upon innovations, technology, government policy, size and composition of population, etc. | Autonomous investment depends on socio-economic and political conditions of the country.
|
Aggregate Demand
Consumption can be autonomous (independent of income) and induced (dependents on income).
Investment undertaken by firms is on fixed and inventory investment and is assumed to be independent of income levels.
In other words there is only autonomous investment and no induced investment.
Consumption and investment represent the planned or desired levels that households and firms respectively would like to consume and invest at different levels of income.
The aggregate demand schedule is the tabular representation of the relationship between income levels and aggregate demand in an economy.
In a two-sector model the aggregate demand schedule is obtained by adding the autonomous investment levels to the consumption function.
Aggregate Supply
Aggregate Supply (AS) measures the money value of goods and services that all the producers are willing to supply in an economy in a given time period.
When aggregate supply is expressed in physical terms, it refers to the total output of goods and services in an economy.
Aggregate Supply = National Income
The value of national output is the cost that was planned to be incurred on producing it.
The cost of production is the amount to be paid (known as factor payments) to the different factors of production (land, labour, capital and enterprise).
We know, the sum total of all factors payments (i.e., rent + wages +interest + profit) is termed as the national income (y).
Diagrammatic Representation of AS
The aggregate supply curve and national income curve coincide with eachother as both (AS and Y ) increase simultaneously and in the same proportion.
It is because of this fact the aggregate supply curve is represented by a 450 line, originating from the origin.
Income is represented on the X-axis and consumption and saving are measured on the Y-axis. A 45° line, which represents the aggregate the aggregate supply, has been drawn by taking the same scale on both the axes.
At every point on the axes, then AB and AC will be equal to (C+S).
Significance of 45° Line
The 45° line starts from the origin 0.
Any point, on this 45° line, will be equidistant from both the axes.
In other words, perpendiculars drawn, from any point on this line, on the X-axis and the Y-axis will be equal.
If a perpendicular is drawn from point A on both the axes, then AB and AC will be equal.
Determination of Equilibrium Level An economy is in equilibrium when the aggregate demand for goods and services is equal to the aggregate supply during a period of time. So, equilibrium is achieved when:
AD = AS (1)
We know, aggregate demand comprises of planned expenditure on consumption (C) and planned expenditure on investment (I).
Symbolically:
AD=C+I (2)
Also, aggregate supply is the sum total of consumption (C) and savings (S).
Symbolically:
AS=C+S (3)
Substituting (2) and (3) in (1),
we get: C+S=C+I Thus, S =
1. AD = AS (Aggregate Demand — Aggregate Supply Approach)
2. S = I (Saving — Investment Approach)
Equilibrium Determination by Aggregate Demand and Aggregate Supply Approach
According to the Keynesian theory, the equilibrium level of income in an economy is determined when the aggregate demand (AD) for goods and services is equal to the aggregate supply (AS).
1. Aggregate demand refers to the total expenditure of the economy. It comprises of planned expenditure on consumption and planned expenditure on capital goods. The aggregate demand curve is, therefore, represented by the (C + I) curve in the income determination analysis.
2. Aggregate supply is the total output of goods and services of the national income. It is depicted by a 45° line. Since the income received is either consumed or saved, the aggregate supply curve is represented by the (C + S) curve.
3. The equilibrium level of income is Rs.400 crores, when the aggregate demand and aggregate supply are equal at Rs.400 crores. Income is measured on the X-axis and aggregate demand on the Y-axis. The AD and AD curves intersect each other at point ‘E’. It is the equilibrium point and ‘OY’ is the equilibrium level of income.
1. When AD is more than AS(AD>AS, i.e., before point ‘E’ ). If AD is greater than AS, it means that the planned level of expenditure (AD) is greater than what the firms are willing to produce (AS). As a result, the planned inventory falls below the desired level. To bring back the inventory at the desired level, firms plan to increase the production till aggregate demand and aggregate supply become equal to each other.
2. When AD is less than AS(AD<AS, i.e., after point ‘E’). If AD is less than AS, it means that firms are willing to produce more than the planned inventory level of expenditure. As a result, planned inventory starts rising and moves above the desired level.
Equilibrium Determination by Saving and Investment Approach
1. According to this approach, the equilibrium level of income is determined at a level, when planned savings (S) are equal to the planned investment (I).
2. Equilibrium is determined at the income of rs.400 crores are equal, when planned savings of r s. 40 crores are equal to the planned investment of rs.40 crores.
3. Investment curve (I) is parallel to the X-axis because of the autonomous character of investments. The savings curve (S) slopes upwards showing that as income rises, saving also rises. The saving and investment curves intersect each other at point ‘E’. It is the equilibrium point and the corresponding equilibrium level of income is ‘OY’.
At point ‘E’, ex-ante savings are equal to the ex-ante investments.
4. Two other situations may occur.
(i) When saving is more than Investment (S > I, i.e., after point ‘E’)
If planned savings are more than the planned investments, it means that households are not consuming as much as the firms expected then to As a result, the inventory rises above the desired level. Due to increase in inventory, firms would plan to reduce the production till savings and investments become equal to each other.
(ii) When saving is less than Investment (5 > I, i.e., before point ‘E’).
If planned savings are less than planned investments, it means that household are consuming more than savings less than what the firms expected them to. As a result, the planned inventory back to the desired level, firms plan to increase the production till savings and investments become equal to each other.
Concept of Investment Multiplier
Keynes believed that an initial increment in investment increases the final income by many times. Multiplier explains how many times the income increases as a result of an increase in the investment. For example, if an additional investment of Rs. 10 crores increase the income by Rs. 40 crores, than there is four times increase in the income as compared to the investment. multiplier refers to the ratio of change in income to a change in investment.
Symbolically:
K= Change in Y / Change in I
Where: k = Investment Multiplier
Change y = Change in National Income
Change in I = Change in Investment
Multiplier is directly related to MPC and inversely related to MPS
The value of multiplier depends upon the value of marginal propensity to consume. Multiplier (k) and MPC are directly related, i.e., when MPC is more, k is more and vice-versa.
The value of multiplier is inversely related to MPS. As MPS rises, multiplier falls. Maximum Values of Multiplier The maximum value of multiplier is infinity (when the value of MPC is unity). When MPC = 1, the economy decides to consume the whole of its additional income. Here, the value of multiplier in infinity.
We know, k = 1 / 1 -MPC
When MPC 1,
than k = 1/ 1- 0
or k = 1/ 0
Minimum Value of Multiplier
The minimum value of multiplier is one. When MPC = 0, the economy decides to save the whole of its additional income. Here, the value of multiplier is equal to 1.
We know, k = 1-MPC
When MPC = 0,
than k = 1 / 1-0
k = 1/1
MEASURES TO CONTROL EXCESS AND DEFICIENT DEMAND
The problems of excess demand and deficient occur when it current aggregate demand is more or less than the aggregate demand required for full employment equilibrium
These problems can be solved by bringing a change in the level of aggregate demand in the economy
1. Change in Government Spending
Government spending is an important component of aggregate demand
This measures is a part of fiscal policy and it is termed as ‘Expenditure Policy of the government
Government spends huge amount on public works like construction of roads, flyover:, buildings etc
2. Change in Availability of Credit
The Reserve Bank of India (RBI) is empowered to regulate the availability of cridit and money supply in the economy through its ‘Monetary Policy’.
Monetary polity help: to, control the situations of excess and deficient demand through its following instruments
(i) Quantitative instruments: These instruments air, to influence the total volume of !redo is circulation. Major instruments or measures are: (a) Bank Rate and Repo Pate:, lb) Open Mark,’ Operation, and (c) Legal reserve requirements.
(ii) Qualitative Instruments: These instruments aim to regulate the direction of credit. Major qualitative instruments or measures are. (a) Margin requirements, (b) Moral suasion, arid 1,,1 Selective Credit Controls.
Decrease in Government Spending
It is a part of fiscal policy.
Government spends huge amount on infrastructural and administrative activities.
To control the situation of excess demand, government should reduce its expenditure to the defense and unproductive works as they rarely help in growth of a country.
Decrease in government spending will reduce the level of aggregate demand in the economy and helps to correct inflationary pressures in the economy.
Decrease in Availability of Credit
The Central Bank (RBI) aims to reduce availability of credit in the economy through its ‘Monetary Policy’. Two major instruments of monetary policy, used to decrease availability of credit are:
(i) Quantitative Instruments;
(ii) Qualitative Instruments.
(i) Quantitative Instruments
1. Increase in Bank Rate:
The term ‘Bank Rate’ refers to the rate at which central bank lends money to commercial banks as the lender of last resort.
During excess demand, central bank.
It forces the commercial banks to increase their lending rates, which discourages borrowers from taking loans.
It reduces the availability of credit in the economy and helps to correct excess demand.
2 Open Market Operations (Sale of securities)
An open market operation refers to sale and purchase of securities in the open market by the central bank.
It directly influences the level of money supply in the economy.
During excess demand, central bank offers securities for sale.
Sale of securities reduces the reserves of commercial banks.
It adversely affects the bank’s ability to create credit and decreases the level of aggregate demand in the economy.
3.Increases in Legal Reserve Requirements (LRR):
Commercial banks are obliged to maintain legal reserves. An increase in such reserves is a direct method to reduce the availability of credit.
There are two components of legal reserves:
(i) Cash Reserve Ratio (CRR):
It is the minimum percentage of net demand and time liabilities, to be kept by commercial banks with the central bank.
(ii) Statutory Liquidity Ratio (SLR):
It refers to minimum percentage of net demand and time liabilities, which commercial banks are required to maintain with themselves.
(ii) Qualitative Instruments
1. Increasing in Margin Requirements:
Margin requirement refers to difference between the market value of security offered and the value of amount lent.
When the economy is suffering from excess demand, central bank increases the margin, which restricts the credit creating power of banks.
2. Moral Suasion (Advise to Discourage Lending):
This is a combination of persuasion and pressure that central bank applies on other banks in order to get them act, in a manner, in line with its policy.
Moral suasion is exercised through discussions, letters, speeches and hints to banks.
During excess demand the central bank advises, requests or persuades the commercial banks not to advance credit.
3. Selective Credit Controls (Introduce Credit Rationing):
It refers to a method in which the central bank gives directions to other banks to give or not a give credit for certain purposes to particular sectors.
During excess demand, the central bank introduced rationing of credit in order to prevent excessive flow of credit.
Increase in Government Spending
It is a part of fiscal policy.
Government incurs expenditure on infrastructural and administrative activities. During deficient demand, the government should increase expenditure on public works like construction of roads, flyovers, buildings, etc. with a view to provide additional income to people.
Increase in Availability of Credit
(i) Quantitative Instruments
1. Decrease in Bank Rate:
The term ‘Bank Rate’ refers to the rate at which central bank lends money to commercial banks as the lender of last resort.
During deficient demand, the central bank reduces the bank rate in order to expand credit.
It leads to fall in the market rate of interest which induces people to borrow more funds.
It ultimately leads to increase in the aggregate demand.
2. Open Market Operations (Purchase of securities):
Open market operations refer to sale and purchase of securities in the open market by the central bank.
It directly influences the level of money supply in the economy.
During deficient demand, the central bank starts purchasing securities from the open market.
It increases the money supply and enhances the purchasing power capacity and increases level of aggregate demand in the economy.
3. Decrease in Legal Reserve Requirements (LRR):
Commercial banks are obliged to maintain legal reserves. Decrease in such reserves helps to raise the availability of credit. There are two components of legal reserves:
(a) Cash Reserve Ratio (CRR):
It is the minimum percentage of net demand and time liabilities, to be kept by commercial banks with the central bank.
(b) Statutory Liquidity Ratio (SLR):
It refers to minimum percentages of net demand and time liabilities, which commercial banks are required to maintain with themselves.
(ii)Qualitative Instruments
1. Decrease in Margin Requirements:
Margin requirement refers to difference b/w the market value of security offered and the value of amount lent.
During deficient demand, central bank reduces the margin, which enhances the credit creating power of banks.
With decreases in margin, commercial banks can grant more loans than before, against the same amount of security.
2. Moral Suasion (Advise to Encourage Lending):
This is a combination of persuasion and pressure that central bank applies on other banks in order to get them act, in a manner, in line with its policy.
During deficient demand, the central bank advises, request or persuades the commercial banks to encourage credit.
3. Selective Credit Controls (Withdraw Credit Rationing):
It refers to a method in which the central bank gives directions to other bank: to give or not to give credit for certain purposes to particular sectors.
During deficient demand, the central bank withdraws rationing of credit and make efforts to encourage credit.