VIKAS RANJAN || AGGREGATE DEMAND AND RELATED CONCEPTS NOTES ||

CH7- AGGREGATE DEMAND AND RELATED CONCEPTS

1. Aggregate Demand:

(a) Aggregate demand refers to the total demand for final goods and services in an economy during an
accounting year.

(b) Aggregate demand is aggregate expenditure on ex-ante (planned) consumption and ex-ante
(planned) investment that all sectors of the economy are willing to incur at each income level.

Note: In terms of Keynes, aggregate demand refers to the total amount of money, which the buyers are
ready to spend on purchase of goods and services, produced in an economy during a given period. It
should be kept in mind that Keynes measured aggregate demand not in terms of physical goods and
services but as a part of total income that society is ready to spend.

(c) Components of aggregate demand: The components of aggregate demand are:

(i) Private (or Household) consumption demand

• The total expenditure incurred by all the households of the country on their personal consumption is
known as private consumption expenditure.

• Consumption demand depends mainly on disposable income and propensity to consume.

(ii) Private investment demand

• Private investment demand refers to the demand for capital goods by private investors.

• It is addition to the existing stock of real capital assets such as machines, tools, factory – building etc.

• Investments demand depends upon marginal efficiency of capital (Marginal efficiency of investment)
and interest rate.

• 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

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(iii) Government demand for goods and services Its curve is upward sloping rises up to Right.

• In a modern economy, the government is an important buyer of goods and services.

It is income inelastic, i.e., it is not affected by change in income level. The volume of autonomous
investment is the same at all levels of income.

Its curve is a straight line parallel to horizontal axis.

• The government demand may be on account of public needs for roads, schools, hospitals, power,
irrigation etc, for the maintenance of law and order and for defence.

(iv) Demand for net export (X – M)

• Net export represents foreign demand for goods and services produced by an economy.

• When exports exceed imports, net exports is positive and when imports exceed, net exports is
negative.

• Exports and imports of a country are influenced by a number of factors such as foreign trade policy,
exchange- rate, prices and quality of goods etc.

Thus, aggregate demand consists of these four types of demand.

However, for the sake of simplicity Keynes included only two types of demand,

-> Consumption demand (C)

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-> Investment demand (I)

Aggregate demand can be explained with the help of AD schedule and AD curve.

2. Aggregate Supply:

(a) The concept of aggregate supply (ΔS) is related with the total supply of goods and services by all the
producers in an economy. Four factor of production like land,

labour, capital and enterprise are required for the production of goods and services. Producers pay rent
to land, wages and salaries to labour, interest to capital and Profits to the entrepreneur for their services
in production. This payment is factor- cost from producer’s point of view and factor-income from factor-
owner angle.

(b) Thus, aggregate supply is the total amount of money value of goods and services, (which is paid to
the factor of production against their factor services) that all the producers are willing to supply in an
economy. In other words, it is the total cost of production of goods and services produced in a country
or it is the value of net national product at factor cost (NNPFC). Thus, the main components of aggregate
supply are:

(c) Keynes assumed his economy to be a closed capitalist economy and whenever any economy is
closed capitalist, then Net Factor Income from Abroad (NFIA) is 0. National Income (NNPFC) = Domestic
Income (NDPFC) + Net Factor Income from Abroad (NFIA)
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National Income (NNPFC) = Domestic Income (NDPFC) + 0

In short,

Aggregate Supply = NNPFC = NDPFC = Factor Income = Rent + Interest + Wages + Profit

(d) As we know income is either consumed or saved, hence for the sake of simplicity Keynes has
regarded only two main constituents of aggregate supply:

Consumption Function
(Propensity To Consume)And its types,Saving Function (Propensity To Save) And Its Types

1. Consumption function expresses functional relationship between aggregate consumption and

national income.

Thus, consumption (C) is a function of income (Y). C = F (Y)

Where, C = Consumption; F = Function; Y = Disposable income Consumption at a point of time can be

measured with the equation:
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2. According to Keynes, as income increases consumption expenditure also increases but increase in
consumption is smaller than the increase in income. In other words, consumption lags behind income.
This is called Keynes’ Psychological law of Consumption. According to Keynes, propensity to consume of
the people remains stable in the short period.

3. Break-even point refers to that point in the level of income at which consumption is just equal to
income. In other words, whole of income is spent on consumption and there is no saving. Below this
level of income, consumption is greater than income but above this level, income is greater than
consumption.

In the given imaginary household schedule of consumption and saving, at annual

income level of Rs.60,000, consumption is Rs.60,000 and in consequence there is no

saving. This is break-even point.

It is evident from the table and diagram that:

(i) As the income increases, consumption also increases, but the increase in consumption remains less
than the increase in income.

(ii) Income can be zero but consumption can never be zero in the economy.

(iii) When C > Y, saving are negative.

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(iv) When C = Y, savings are zero. This is known as break-even point. This is shown by point E in the
diagram. Thus break-even point indicates a point where consumption becomes equal to income or
consumption curve cuts the income curve.

4. There are two types of propensity to consume:

(a) Average propensity to consume (APC)

(i) The ratio of aggregate consumption expenditure to aggregate income is known , as average
propensity to consume. It indicates the percentage (or ratio) of income which is being spent on
consumption. It is worked out by dividing total consumption expenditure (C) by total income (Y).

A Consumption (C)

(ii) It can be explained with the help of following schedule and diagram:

(iii) Important Points for APC:

• When APC is more than 1: When APC is more than 1, consumption is more than national income, i.e.
before the break-even point.

• APC = 1: When APC is equal to 1, consumption is equal to national income, which is known as to be
break-even point.

• When APC is less than 1: When consumption is less than national income, i.e. beyond the break-even
point.

(b) Marginal Propensity to consume (MPC):

(i) The ratio of change in consumption (C) to change in income (Y) is known as marginal propensity to
consume. It indicates the proportion of additional income that is being spent on consumption.
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(ii) It can be explained with the help of following schedule and diagram:

(iii) Important points for MPC:

• Value of MPC varies between 0 and 1: As we know that increase in income is either spent on
consumption or saved for future use.

• MPC falls with the successive increase in income: It happens because as an economy becomes richer,
it has the tendency to consume smaller percentage of each increment to its income.
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5. (a) Propensity to save (or saving function) shows the functional relationship between aggregate
savings and income.

It is evident from the saving-function schedule and diagram that as income increases saving also
increases. Saving can be both negative and positive. Prior to break-even point saving is negative, at
break-even point saving is zero and after the break-even point saving is positive.

(c) Important points for Saving function:

(i) Starting Point of Saving Curve:

• Saving curve (SS) starts from point _c on the Y-axis, indicating that there is negative saving (equal to
amount of autonomous consumption) when national income is zero. Note: The saving curve will have a
negative intercept on Y-axis of the same magnitude as the consumption curve has positive intercept on
the Y-axis. It happens because if consumption is positive at zero level of income, then there would be
dis-savings of the same magnitude.
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• Break-even point (S = 0).

Saving curve crosses the X-axis at point R which is known as break-even point as at this point saving is
zero (or consumption is equal to income).

• Positive Saving: After the break-even point saving is positive.

6. Types of propensity to save

(a) Average propensity to save (APS):

(i) The ratio of aggregate saving to aggregate income is known as average propensity to save (APS). By
dividing aggregate saving by aggregate income, we get APS. Symbolically,

(ii) Important Points for APS:

• APS can never be 1 or more than one.

As saving can never be equal to or more than national income.

• APS can be 0: APS is 0 when income is equal to consumption i.e., saving = 0. This point is known as
break-even point.

• APS can be negative or less than 1.

At income levels which are lower than the break-even point APS can be negative as there will be dis-
savings in the economy.

• APS rises with increase in income.

• APS rises with the increase in income because the proportion of income saved keeps on increasing.
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(b) Marginal Propensity to Save:

(i) The ratio of change in saving (ΔS) to change in income (ΔY) is called MPS. It is proportion of income
saved out of additional (incremental) income. Symbolically,

Words that Matter

1. Aggregate demand: It is aggregate expenditure on ex-ante (planned) consumption and ex-ante

(planned) investment that all sectors of the economy are willing to incur at each income level.

2. Induced Investment: It refers to the investment which is made with the motive of earning profit.

3. Autonomous Investment: It refers to the investment, which is made irrespective of level of income.

4. Aggregate Supply: Aggregate supply is the total amount of money value of goods and services, (which
is paid to the factor of production against their factor services) that all the producers are willing to
supply in an economy.
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5. Consumption Function: Consumption function(Propensity to consume) expresses functional

relationship between aggregate consumption and national income. Thus, consumption (C) is a function
of income (Y).

C = F (Y) and C = C + b Y

6. Autonomous Consumption: It refers to minimum level of consumption i.e. (c), which is needed for
survival, i.e., consumption at zero level of national income.

7. Keynes’ Psychological law of Consumption: According to Keynes, as income increases consumption

expenditure also increases but increase in consumption is smaller than the increase in income. In other
words, consumption lags behind income.

8. Break even Point: Break-even point refers to that point in the level of income at which consumption is
just equal to income. In other words, whole of income is spent on consumption and there is no saving.

9. Average Propensity to Consume: The ratio of aggregate consumption expenditure to aggregate

income is known as average propensity to consume.

APC=C/Y

10. Marginal Propensity to consume: The ratio of change in consumption (C) to change in income (Y) is
known as marginal propensity to consume. It indicates the proportion of additional income that is being
spent on consumption.

MPC=ΔC/ΔY

11. Saving Function: Saving function (Propensity to save) shows the functional relationship between
aggregate savings and income.

S = f (Y) and S = — C + (1 — b) Y

12. Average Propensity to Save: The ratio of aggregate saving to aggregate income is known as average
propensity to save (APS).

APS=S/Y

13. Marginal Propensity to Save: The ratio of change in saving (ΔS) to change in income (ΔY) is called
MPS. It is proportion of income saved out of additional (incremental) income. Symbolically,

MPC= ΔS/ΔY