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Aggregate Demand and Aggregate Supply


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It is income elastic. That means such type of investment is directly or positively linked with profit. Changes in price level, interest fate, consumption pattern, changes in the level of income, possibility of high profit margins, savings, supply of money, availability of credit, etc.

In the modern economy, government is an important buyer of goods and services on a large scale. Government purchases of goods and services constitute government demand. Government incurs expenditure is done for the purpose of maximizing welfare and having maximum growth and development. Government's expenditure, is done either - for consumption purposes 6i,, for investment purpose.

Government's consumption expenditure includes expenditure on defence, police, maintenance of law and order, public utilities, such as water, electricity, parks, etc. Government's investment expenditure includes the expenditure incurred on increasing the stock of capital assets in the economy. It includes expenditure on economic and social overheads, such as transport and communication, banking; finance and insurance, irrigation facilities, education, health, etc.

All these government expenditures add to aggregate demand in the economy. In modern period, due to development in science and technology, means of transport and communication, it is observed that international trade among different countries has increased: There are two sides of international trade, 1 Import and 2 Export. It refers to purchase of goods and services, capital as well as consumer goods by a country from different countries in the world.

When goods and services are imported from other countries, importing country has to make payment to foreigners in terms of foreign exchange. When a country exports goods, it receives income in the form of foreign exchange, which can be utilized by a country, to import required goods and services. Net Earnings from foreign transactions can be obtained by finding a difference between value of export and import. It can be calculated as follows: Net earning from foreign transactions can be positive, negative or even zero.

When a country's export is more than the import, net earning from foreign transactions will be positive; when import is more than export, net earning from foreign trade will be negative; arid when the export is exactly equal to import, earning from foreign trade will be zero. When net earning from foreign trade is positive, it is to be added to national income, when it is negative, it is to be, deducted and when it is zero, it does not affect national income.

It essentially refers to the total national product or national income. The determinants of Aggregate Supply can be shown in the following formula: It is the minimum expectations of entrepreneurs from the market to cover their cost of production.

Wherever we use the bar - it indicates that the factor supply is held constant, during the short run. Now let us consider these factors in details and understand their effect on aggregate supply.

Natural resources include all those natural gifts, which are on the surface, below the surface and above the surface of the earth. If a country has plentiful supply of natural resources like fertile soil, temperate and moderate climate, perennial rivers and regular and satisfactory rainy season, availability of essential minerals and such other essential industrial raw materials, it follows that aggregate supply in such a country as for example: Aggregate supply is also greatly influenced by the amount of available labour force in the country.

Thus, if the labour force in a country is abundant, highly skilled, industrious and highly motivated, devoted, dedicated to work hard and to produce all types of goods and services, with a view to earn rising income that would enable it, to enjoy rising standard of living, such as labour force will have great influence on aggregate supply of output of goods arid services.

Japan, China and Korea are the best examples of the countries having great influence of labour force on aggregate supply. Capital is a man-made factor of production. Aggregate supply depends upon the stock of capital. The use of capital helps to increase the productivity and efficiency of other factors of production.

Capital formation and accumulation of capital depends upon the savings made by the people in the country. Saving depends upon the level of income. Savings are converted into investment of capital goods.

Greater the investment, greater is the accumulation of capital thus greater the availability of capital for production. The aggregate supply and employment in the economy depends upon the stock of capital, its quality and use. Raw materials, machinery tools, electricity generation plants, roads, dams, factory buildings, plants, etc.

During the short run, it is not possible to produce and supply these things, and therefore during the short run the supply of capital is fixed. Aggregate supply is also greatly influenced by the state of technical knowledge, at any particular moment of time. The use of new technology means using scientific knowledge acquired through research in the production process.

With the use of modern technology, it is possible to explore new resources and the new use of available resources. For example, exploration of new sources of oil wells in the ocean is possible, because of the adoption of modern technology. The productive capacity of the economy increases due to the adoption of modern technology. Improvement in the quality of production is also possible. Large-scale production with minimum cost is also possible because of the use of new technology.

For example, use of computer and internet in business and industries has facilitated expansion of business transactions. The productive efficiency of capital and labour increases with the use of modern technology. According to Lord Keynes, the equilibrium level of employment, output and income, at any time, depends on effective demand in an economy.

The higher the effective demand, higher is the level and volume of employment and lower the effective demand lower will be the volume and level of employment. Deficiency in effective demand will result in unemployment. Effective demand is the actual expenditure incurred by all the people, on all types of consumer goods and capital goods in the economy during a given period of time.

The flow of expenditure, in turn, determines the flow of income. Hence, in the economy -. According to Keynes the level of effective demand is determined by the intersection of Aggregate Demand Function A. F and Aggregate Supply Function A. Aggregate Demand Function A. Aggregate Demand Function or Aggregate Demand is measured with the help of aggregate demand price. Here, price means expected maximum sales proceeds. Thus, aggregate demand price refers to what the households and firms are expected to spend on the purchase of different goods and services in the economy.

It is this expenditure which becomes the actual sales proceeds or the revenue which producers expect to earn at a given level of employment from the sale of output.

With the increase in the level of employment, aggregate demand price also increases and there is a positive relationship between the level of employment and aggregate demand price. The ADF is a positive function of the level of employment and output. In the figure 9.

The X axis shows the volume or levels of output and employment. The ADF Curve slopes upwards from left to right because, as the level of output and employment increases, income and expenditure of workers also increases. This, in turn increases the aggregate expected sale proceeds. Aggregate Supply Function or Aggregate Supply, is measured with the help of aggregate supply price. Here price implies minimum sales proceeds.

In order to produce goods and services, the producers employ different factors of production and pay them in the form of wages, rent, interest, etc. This cost of production including the normal profits must be recovered through sale proceeds. Aggregate supply price is the minimum amount of money sales proceeds , which all the entrepreneurs in the economy must receive from the sale of output produced by them, at any given level of employment.

If they do not receive this minimum amount, they will reduce output and employment. According to Keynes, aggregate supply price is the minimum sales proceeds which the producers must get to continue production at any given level of employment. The curve slopes upwards to the right as employment increases. In the beginning, it rises slowly and then rapidly. This is because cost of production increases as more and more people are employed.

Hence, the minimum sales proceeds required also rise. Once all the persons willing to work get employed, then we have full employment point F on X axis. The ASF Curve becomes a vertical line, parallel to Y axis that is, perfectly inelastic , after the full employment level F , has been achieved in the economy.

This indicates that even if aggregate supply price increases, employment cannot increase. Above point Q in the figure,. According to Keynes effective demand is determined with the intersection of aggregate demand and aggregate supply in the economy.

The aggregate demand consists of consumption demand, investment demand, government demand, and foreign demand.

Similarly aggregate supply depends on natural resources, labour, capital and technology. The equilibrium point of effective demand is that point, where aggregate demand function equals to aggregate supply function. Effective Demand can be shown in the following diagram. Keynes explains the relationship between consumption C and income Y , in terms of his psychological law of consumption.

According to this law, as aggregate income increases, the total consumption expenditure in the economy also increases, but in a lesser proportion than the increase in income. In other words the proportion of income spent on consumption goes on falling as income increases.

This is because as income increases, the individual wants are satisfied to a larger and larger extent. So when income increases further, people do not consume the entire income. They save a part of it. Hence, there is bound to be a gap between income and consumption. According to Keynes, with the increase in income, both consumption and savings increase; but a consumption increases at a diminishing rate, and b saving increases at an increasing rate.

It is common observation that as the income of an individual rises, his consumption expenditure also rises, but not to the full extent of rise in income of the individual. Broadly, it may be sold that this rule of consumption is true of the community as a whole, as the community is composed of individuals. The following table indicates how consumption expenditure C rises with rise in income Y. Consumption and Saving Function. The table related to Aggregate Income and Aggregate Consumption Expenditure indicates that initially the people have to manage their minimum consumption expenditure, even if there is no income.

This is autonomous consumption expenditure. Although income is zero, some people have to spend, some amount on consumption in order to keep their body and soul together.

If income is zero, some people may be required to borrow or beg or resort to dissaving i. Thus, one part of expenditure on consumption is independent of income and is constant or autonomous. At this level, income Y is equal to consumption expenditure C hence, saving S is zero. Thus, with increase in the level of income, consumption expenditure does not increase at the same rate. There is a gap between aggregate income and consumption expenditure.

Keynes' psychological law of consumption states that "as income goes on increasing, the consumption also increases but at a rate less than increase in income. Following is the diagrammatic representation of the behaviour of consumption function as given in the psychological law of consumption. OA on the vertical axis shows autonomous consumption at zero level of income. At this point consumption is equal to income. The Propensity to Consume, which is also called consumption function, is an expression of an empirical income consumption relationship.

Keynes states that other things being equal consumption is a function of income. Algebraically, the relationship between consumption, as a dependent variable, and aggregate income, as the independent variable, is expressed as: The Propensity to Consume or the consumption function shows the relationship between aggregate consumption expenditure C and aggregate income Y.

The Propensity to Consume does not mean a mere desire to consume, but the actual amount of real consumption, that takes place or that is expected to take place at various income levels. We can construct a schedule of propensity to consume, by using the same data, which is used in understanding the Keynesian Psychological Law of Consumption. Schedule of Propensity to Consume. Aggregate Income in crore.

Aggregate Consumption in crore. Average Propensity to Consume. Marginal Propensity to Consume. A schedule of the -propensity to consume is a statement showing the functional relationship between the level of aggregate consumption and aggregate income at each level of income. Two aspects of Propensity to Consume, viz. In dealing with the Propensity to Consume or consumption function, Lord J.

Keynes considered its two technical attributes: The Average Propensity to Consume A. The Average Propensity to Consume APC is defined as the ratio of aggregate consumption to aggregate income in a given period of time. The value of average propensity to consume, for any income level, may be calculated by dividing consumption by income. In the schedule of Propensity to Consume Table 9. Thus in the Long Run we define the Aggregate Supply AS LR function as being influenced by those elements included in the production function and independent of the price level.

A supply-side shock, such as an increase in labor productivity, would shift AS outward -- there is a greater potential to produce at each and every price level.

We can see this change in figure 1 to the left. As prices fall, purchasing power increase reflecting an increase in the ability to spend i. The net result in an increase in output and spending and a lower price level. In figure 2 to the left, we have a demand-side shock perhaps the result of an increase in government spending. This shock shifts the AD relation outward. Initially there is an excess demand for goods A to B evidenced by a depletion of inventories.

Given that potential output has not changed, in time this excess demand will cause the price level to increase. As prices increase, purchasing power falls and the ability to spend decreases B to C. The net result of this shock is an increase in the price level with no change in output or real spending.

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The determinants of aggregate supply (Points: 1) are consumption, investment, government, and net export spending. explain why real domestic output and the price level are directly related. explain the three distinct ranges of the aggregate supply curve. include resource prices and resource productivity.

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The following table lists several determinants of aggregate supply. Fill in the table by indicating the changes in the determinants necessary to increase aggregate supply%(2). Determinants of Aggregate Supply. Changes in labor force: Anything that causes the amount of workers to increase in an economy will cause aggregate supply to increase or shift to the right. If the labor force decreases, the overall supply of .

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Determinants of aggregate supply This graph shows a decrease in aggregate supply in a hypothetical economy where the currency is the dollar. Specifically, the short-run aggregate supply curve () shifts to the left from to, causing the quantity of output supplied at a price level of to fall from $ billion to $ billion%(1). The determinants of aggregate supply: a) are consumption, investment, government, and net export spending. b) explain why real domestic output .