Aggregate Demand And Its Components:

Meaning and concept of Aggregate Demand;

Aggregate demand refers to the total value of final goods and services which all the sector of an
economy are planning to buy at a given level of income during a period of one accounting year.
Aggregate demand is the aggregate expenditure that different sectors of the economy are willing to
(in) during a given period. It means aggregate demand and aggregate expenditure means the same. It
is important to note that aggregate expenditure refers to planned .Expenditure and not the actual.
Expenditure so, aggregate demand is the total expenditure that all the households, firms and government
and the rest of world are planning to ncer during a given period of time.
Components of aggregate demand:The various components of aggregate demand are:1. Private (Household) consumption expenditure (c):- It refers to the total expenditure incurred
by households on purchase of goods and services during an accounting year.
Higher the disposable income more is the consumption expenditure.
2. Investment expenditure (I): - It refers to total expenditure incurred. By all private firms on
capital goods.
3. Government expenditure (G):- It refers to total expenditure incurred .By government on
consumer goods and capital goods to satisfy the common needs of the economy.
4. Net export :- (X-M):- Exports indicate demands for goods produced within the domestic
territory of a country by the rest of the world. Imports refer to demand of the residents of a
country for the goods that have been produced abroad.
The difference between exports and imports is farmed as net exports.
AD = C+I+G+(X-M)
C = consumption expenditure
I = Investment
G = Government expenditure
X = Exports
M = Imports
AD = Aggregate demand
Components of aggregate demand are studied with reference to
1. Closed economy
2. Open economy
(1) Components of aggregate demand in a closed economy: -

AD = C+I
A two sector model includes (1) Household sector and (2) producer sector.
Specifically there is no government sector in this economy form the view point of components of and
household make consumption expenditure and producer make investment expenditure.
(2) Components of aggregate demand in an open economy: AD = C+I+G+(X-M)
It includes four sectors: 1. Household sector 2. Producer sector 3. Government sector 4. Rest of the
world
Behaviour of aggregate demand :(AD) AD is the sum total of c and I (consumption expenditure +
investment expenditure ) that the people wish to make corresponding to different levels of income (Y)
in the economy.
AD is studied in relation to Y( income) thus behavior of AD means how AD change when Y changes.
The relationship between AD and Y is expressed in terms of AD schedule which shows the level of AD
corresponding to different levels of Y.
Y
0
20
40
60
80
100
120

AD = C+I
30
35
40
45
50
55
60

1. There is always some minimum level of expenditure in the economy even when level of expenditure
in the economy even when Y= 0
2. AD increases as Y increases. Thus, AD is positively related to Y.
3. Alter a certain level of Y is reached AD lags behind Y>this happens because at higher levels of Y
people start saving a part of their income.
45 line is a line of reference each point on this show that Y = AD
When AD = Y when Y = Rs.40 core
Minimum level of AD =30 core

This indicates expenditure independent of the level of income in the economy.

Aggregate demand in a two sector:Model (AD = C+I)
Income
(Y)
0
100
200
300
400
500
600

Consumption (C)

Investment (I)

40
120
260
280
360
440
520

20
20
20
20
20
20
20

AD
60
140
220
300
380
460
540

AD

--------------------------------------------I
X

AD depends upon the level of income in the economy. Generally there exist a positive relationship
between income and level of aggregate expenditure in the economy .i.e. as the level of income rises, AD
also raises and vice-versa.
Positive consumption when income level is zero : There is always some minimum
level of consumption ,even when the income is zero .It happens because people need
certain basic goods and services to certain themselves ,even it income is zero borrowing
or disserving.
In the table consumption of Rs.40 core when Y (income) is zero is termed as autonomous
consumption (c)
Slope of consumption curve: - The first component of AD, i.e. consumption curve
slopes upward because consumption increases with increase in income. However
proportionate increase in consumption is less than that of income .It happens because
after reaching a particular level people start saving a part of their income.
Slope of autonomous investment curve:- the second component investment
expenditure (I) is a straight line parallel to X-axis as it is assumed to be independent of
the level of income. As seen in table investment remains constant at Rs.20 crores
(autonomous investment)
Starting point of AD curve : AD curve starts from point t,as at zero level of national
income,
AD = autonomous consumption +Autonomous investment

 Slope of AD curve is positive which indicate that AD increases with increase in income.
Aggregate supply: - Aggregate supply refers to money value of final goods and service that all
the producers are willing to supply in an economy in a given fine period.
Aggregate supply = National income.
A major portion of income (Y) is spent on consumption of goods and services and the balance is
saved it means.
Y = C+S
Or AS = Y = C+S
Behaviour of aggregate supply:- In physical terms aggregate supply is the flow of goods and
services in an economy. It can be increased either by using more quantity of existing resources or
by making technology important.
Level of
employm
ent
0
10
20

30

40

50

60

Y
0

50

5
0
1
0
0
1
5
0
2
0
0
2
5
0
3
0
0

75
10
0

50
25
0

AS=
C+S
0
50
100

12
5

25

150

15
0

50

200

17
5

75

250

20
0

10
0

300

The total shows that aggregate supply is increasing in direct proportion to the increase in employment,
but this will happen only till full employment is reached. In fig aggregate supplies represented by a 45

line from the origin. It shows that the valve of flow of goods and services increases or decreases in same
proportion as that of increase or decrease in the level of employment.
The aggregate supply curve can also be obtained by adding consumption and saving schedule as shown
in figure. iv
E- Break even consumption level.
F- Break even saving level.

It can be observed from table and figure that initially total consumption expenditure is more than income
in the economy .therefore there are dissavings in the economy .At Rs.100 crore income, consumption
expenditure is also Rs.100 crore.But beyond income level of Rs.100 crore, both consumption and
income increases but increase in income is greater as compared to consumption expenditure thus the
economy starts saving.

CONSUMPTION FUNCTION (Propensity to consume)

Propensity to consume or consumption function is the ratio that measures the functional relationship
between income and employment.
C = f(Y)

C= consumption
Y = National income
F = Function

It indicates / represent the willingness of household to purchase goods and services a given level of
income during a given time period.
It shows the consumption level at different levels of income in an economy.

Income (Y)
0
50
100
150

Consumption
50
75
100
125

200
150
250
175
300
200
Consumption refers to the amount of income which is spent upon the purchase of goods and services at
a given level of income .But consumption function refers to the whole of the schedule showing
consumption expenditure at various level of income.

Starting point of consumption curve:-Consumption curve (CC) starts from point c on the
Y-axis. This implies that there is autonomous consumption (c) of OC even when the
national income is zero.
Slope of consumption curve:- Consumption curve has a positive slope, which indicate
that as income increases consumption also rises. However proportionate rise income is
higher than in consumption.
Income is less than consumption: - When income is less than consumption the gap is
covered.
Breakeven point: It Om level of income consumption becomes equal to income and
saving is zero. the point E is known as break even point.
Income is more than consumption:-Beyond point E, income is more than consumption
excess of income leads to saving. The gap between the 45 lines and consumption curve
after point E, shows positive savings.
Type of propensities to consume:
Average propensity to consume :( APC):- It refers to the ratio of consumption expenditure to the
corresponding level of income.
APC = Consumption (C)
Income

(Y)

It consumption expenditure is Rs.70 crore at income level of Rs.100, then

APC = pending

= 0.7 i.e 70% of income is spent on consumption

Diagram pending
1. Important point about APC:
1. APC is more than one : as long as consumption is more than national income .i.e. before the break
even point. APC>I
2. APC= I , At break even point ,consumption is equal to national income ,so , APC= I,

3. APC is less than 1:- Beyond the break even point consumption is less than national income. As a
result, APC<I
4. APC falls with increase in income:- APC falls continuously with increase in income because the
proportion of income spent on consumption keeps on decreasing.
5. APL can never be zero:- APL can be zero, only when consumption becomes zero. However
consumption is never zero level of national income. Even at zero level of national income,there is
autonomous consumption CcI.
2. Marginal propensity to consume: - It refers to the ration of change in consumption expenditure to
change in total income
MPC =

change in consumption

Change in income

e.g. It consumption expenditure increase from Rs.70 crore to Rs.110 crores with an increase in income
from Rs.100 crore to Rs.200 crore then,
MPC

110/200, 70/100

= 40/100 = .4

MPC =MN/Y1Y2= C/Y

Important point about MPC.

1. Value of MPC varies between O and I: We know that incremental income is either saved or
spent on consumption.

It entire income is spent on consumption i.e. S= O then MPC=1.

It entire income is saved then C = O i.e. MPC=0

However the value of MPC lies between O and I

2. MPC of poor is more than rich:- It happens because poor people spend a greater percentage of their
increased income on consumption as most of their basic needs remain unsatisfied .
On the other hand rich people spend smaller proportion as they already enjoy a high standard of living.
Similarly MPC of development countries like. India Bangladesh etc is more than MPC of development
countries.
3.MPC falls with successive increase in income:-It happens because as an economy becomes richer, it
has the tendency to consume smaller percentage of each incremented income.

 Saving function (Propensity to save)

Saving function refers to the functional relationship between saving and national income.
S = F(Y)
Where S = Saving
Y = National income
F = Functional relationship
Propensity to save shows the saving of household at a given level of income during a given period .i.e
Propensity to save shows the different levels of saving at different levels of income in an economy.
Income(Y)
0
100
200
300
400
500
600

Consumption( C
)
40
120
200
280
360
440
520

Saving ( S=YC)
-40
-20
0
20
40
60
80

Diagram pending

Important observations from saving schedule and saving curve.

1. Starting point of saving curve:- Saving curve start from point S on the Y-axis ,indicating that
there is negative when national income is zero.
2. Slope of saving curve:- slope of saving curve is positive ,which indicates that saving increase
with increase in income.
3. Breakeven point: Saving curve cross the X-axis at point R, which is known as breakeven point,
at this point saving is zero.
4. Positive saving:- After breakeven point ,saving is positive in the economy.
Average propensity to save (APS):- It refers to the ratio saving to the corresponding level of income.
APC = saving/income S/Y

It saving is Rs.30 crore at national income of Rs.100 crore, than

30%
APS = OR/OY
Diagram pending

APS = S/Y =30/100 =.30 i.e.

Important point about APS.

(i)
(ii)
(iii)

APS can never be 1 or more than 1:- As saving can never equal income national so, APS can
never be 1 or greater than 1.
APS can be zero:-At break even point, where national income is equal to consumption , APS is
zero.
APS can be negative or less than 1:- At income levels which are lower than break even point,
APS can be negative as there will be disssavings in the economy.

(iv)

APS rises with increase in income:-APS rises with increase or income because the proportion
of income saved keeps on increasing.

Marginal Propensity to save (MPS):- Marginal propensity to save refers to the ratio of change in
saving to change in total income.
MPS= change in savings/change in income S/Y

It savings increase from Rs.30 crore to RS.90 crore with an increase in income from RS.100 crore to
Rs.200 crore then
MPS = 90-30/200-100 = 60/100 = .6 60%
Diagram pending
MPS varies between 0 and I
It the entire national income is save then C = 0 and MPS = 1
However if entire additional income is consumed i.e. S = then MPS = 0

Relationship between APS and APC: We know Y = C+S (i)

Divide both sides of (i) by Y, we get V/Y = C/Y+S/Y
1 = APC+APS
Relation between MPC and MPS
We know Y = C+S (i)
Divide both sides of (i) by Y
i.e. Y/Y = C/Y+S/y 1= MPC+MPS
Formulae used.
(i)
(ii)
(iii)
(iv)
(v)
(vi)
(vii)

S =Y-C
APC =C/Y = 1-APS
APS = S/Y =1-APC
MPC =C/Y =1-MPS
MPS=S/Y=1-MPC
MPC+MPS=1
APC+APS=1

Equation of consumption function

C=c+b(Y)
C=consumption
C= Autonomous consumption even when the income (Y) is zero, there is some minimum consumption,
known autonomous consumption (c) which is always positive.
B=MPC
Y=Income

 C=c + MPC(Y)
C=c+(1-mps)+(Y)
Equation of saving function:- S= Y-C (i)
And

C =c+6(Y) (ii)

Put value of c from (ii) in (i)

S = Y-c-6(Y)
S = c+Y-6(Y)
=-c+ (1-6) (Y)

(1-MPC+MPS)

=c=MPS(Y)
Derivation of saving curve from consumption curve
As shows in the diagram cc is the consumption curve and 45. Line OY represents the income level.
At zero level of income autonomous consumption (c) is equal to OC. It means saving at zero
level of income will be OS (-c).As a result, the saving curve from point S on the negative Y
axis.
Diagram pending

Consumption curve cc intersects income curve OY at point E. This is the break even point. At
point E. consumption = income i.e. APS=1 and saving zero i.e. APS =00.It means saving curve
will intersect X-axis at point R. By joining the point S and R and extending it further we get the
saving curve ss.
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, which
lead to increase in the productive capacity of the economy. The investment expenditure is
classified under two heads.
Induced investment: Induced investment is undertaken with the motive of earning profit and
income. It increases with increase in income

As seen induced investment curve II slopes upward from left to right indicating that as income
increase from OY to OY1 investment increases from OM to OM1
Diagram pending

Autonomous investment:- Autonomous investment refers to the investment which is not

attached by change in the level of income and is not induced solely by profit motive. As seen in
the figure the amount of investment remains content at OI, irrespective of level of income (OY or
OY,) in the economy.
This type of expenditure is generally made by government Infrastructural activities.

The level of autonomous investment depends upon the social, economy and political conditions
of the country.
INDUCED INVESTMENT VS AUTONOMOUS INVESTMENT
Induced investment
(i)It is driven by profit motive
(ii) It is directly related with income
(iii) Its curve slope upwards
(IV)It is generally done by private sector

Autonomous investment
It is done for social welfare and not for profit
It does not have any income effect
It curve is parallel to income axis
It is generally done by government sector

Determinants of investment: - The volume of investment is determined by two factors

1. Marginal efficiency of capital (investment)
2. Rate of interest (ROI)
1. Marginal efficiency of investment:- It refers to the expected rate of return from an additional
investment MEI is determined by two factors:(i)
Supply price: It refers to the cost of produced a new asset of that kind. It is the price at
which the new capital can be supplied or replaced .For example if a machine of Rs.10.000 is
replaced in place of old machine , then Rs. 10.000 is the supply price.
(ii)
Prospective Yield: - It refers to net returns (net of all costs) expected from the capital asset
over its life time. For example it the given machine is expected to yield receipts of Rs.1200
and running expenses would be Rs.200 then the prospective yield would br:1200-200=
Rs.1000
In the given example

MEI/MEC =1000/10000*100 = 10%

2. Rate of investment:- It refers o the cost of borrowing money for financing the investment
.There exists an inverse relation between ROI and volume of investment .At high ROI, the
investment spending will be less and vice versa.
Comparison of MEI and ROI
The profitability of an investment can be worked out by company MEI and ROI.
If MEI>ROI then investment is profitable for example it an entrepreneur has to pay 12% rate of interest
on loan acquired by him and the expected rate of profit is 20% (MEI) then be will surely go for
investment and will continue making investment till MEI=ROI.
MEC falls with increase in investment because
(i)
(ii)
(iii)

The marginal revenue productivity of capital falls as more and more units of capital are
employed.
The pressure for producing that type of (good) capital asset causes its supply price to
increase and
The prospective yield fall because of fall in prices of goods produced by capital assets.

Ex-ante investment and EX-Post investment

Ex-ante means planned value of a variable.

Ex-post means actual or realized value of a variable.

(i)
(ii)
(iii)

When a producer makes an investment according to a definite plan both on fixed capital and
investment than that investment is termed as planned investment or intended investment.
Unplanned investment: It is that investment which is involuntary incurred by an investor.
Actual investment or Ex-post investment (Ia) is the sum of planned investment (Ip) and
unplanned investment (Iu).
Ia = Ip+Iu

(a) When Ex-post investment (Ia) is greater than Ex-ante investment (Ip) there will be decrease in
inventories.
(b) When Ex-post investment is less than Ex-ante investment Ip-<Ia. There is increase in
inventories.
Ex-ANTE SAVING AND EX-POST SAVING.
Ex- ante saving refers to amount of saving which household plans to save at different levels of income
in the economy.
Ex-post saving refer to the amount of actual saving or realized saving in an economy during a year.
Full Employment:Full employment refers to a situation in which all those people , who are willing and able to work at
exiting wage rate get work, without any difficulty.
Generally, the term full employment means. There is no unemployment .i.e. everyone gets work. It
means demand for labour is equal to its supply. However, in macro economy there can be some
unemployment even during full employment. It means full employment does not stand for zero
unemployment .
Under full employment, there can be two types of unemployment:
1. Frictional unemployment: It refers to temporary unemployment , which exist during the
period where in workers leave one job and join some other.
2. Structural unemployment: - It is the result of structural change in the economy.
Involuntary unemployment: Involuntary unemployment refers to an unemployment in which all those
people who are willing and able to work at the exiting wage rate, do not get work.

INCOME DETERMINATION AND MULITIPLIER

Determination of equilibrium level:- According to Keynesian theory condition is generally stated in
terms of aggregate demand (AD) and aggregate supply (AS). An economy is in equilibrium when
aggregate demand for goods and services is equal to aggregate supply during period of line.
I.e. when AD= AS (1)
We know AD = C+I -- (2)
And

AS = C+S (3)

Substituting (2) and (3) in (1) we get

C+I = C+S or I=S

Thus Equilibrium is reached when AD = AS or when

S=I

Assumption:(i)
(ii)
(iii)
(iv)

Equilibrium output is studied in context of short term.

It is assumed that investment expenditure is autonomous i.e. investment are not influenced
by level of income
It is studied in context of a closed economy; it means it is assumed that there is no
government sector.
Price level is assumed to remain constant.
Aggregate demand and aggregate supply approach :-

According to this approach, the equilibrium level of income in an economy is determination when
aggregate demand (C+I) AD is equal to total output, (aggregate supply or AS (C+_S))
Aggregate supply is the total output of goods and services of the national income, It is depicted by 45.
Line (line of reference) since the income received is either consumed or saved the AS curve is
represented by the (C+S) curve.

The AD or (C+I) curve shows the desired level of expenditure by consumers and firms
corresponding to each level of income. The economy is in equilibrium at point E

EMPLOYEMN INCOME
(Y)
T
(N)
0
0
10
100
20
200
30
300
40
400
50
500
60
600

Consumption
(C)
40
120
200
280
360
440
520

SAVING
(S)
-40
-20
0
20
40
60
80

INVESTMEN
T
(I)
40
40
40
40
40
40
40

AD
(C+I)

AS
(C+S)

80
160
240
320
400
480
560

0
100
200
300
400
500
600

Where (C+I ) curve intersects the 45. Line

Diagram pending

The table shows both AD and AS are increasing with an increase in employment and so does the
consumption expenditure and saving. Equilibrium will be reached when AD = AS .i.e. when the
AD curve intersects the 45. Line.
In the table the Equilibrium level of income is Rs.400 crore , when AD (OT C+I ) = AS Rs.400
crores

It is a situation of effective demand effective demand refers to that level of AD which becomes
effective, because it is equal to AS.

WHEN AD IS MORE THAN AS (AD>AS)

When planned appending is more than planed output (AS), then (C+I). Curve lies above the 45. Line. It
means that consumer and firms together would be buying more goods than firms are willing to produce,
As a result, the planned inventory would fall below the desired level.
Diagram pending
Firms will be induced to increase production which will lead to increase in the level of
income/output/employment.
The firms will keep of increasing production till AD = AS and there is no further tendency to change.
When AS is more than AD (AS>AD)
When AS> AD then (C+I) curve lies below the 45. Line. It means that the consumers and firms together
would be buying less goods than firms are willing to produce. As a result, the planned inventory would
rise.
To clear the unwanted increase in inventory firms plans to decrease the employment and output unit the
economy is back at output level OY where AD becomes equal to AS and there is no further tendency to
change.
SAVING INVESTMENT APPROACH
According to this approach , the Equilibrium level of income is determined at a level when planned
saving is equal to planned investment .(I)

S indicates with drawl while I indicates injections into the circular flow
Income
0
100
200
300
400
500
600

Consumption
40
120
200
280
360
440
520

Saving
-40
-20
0
20
40
60
80

Investment
40
40
40
40
40
40
40

The figure shows investment curve I is parallel to the X-axis because of autonomous character
of investments.
Diagram pending
The saving curve (S) slops upwards showing that income rises, saving also rises.
The economy is in Equilibrium when saving and investment curve intersect each other at point E
At point E ex-ante saving is equal to ex-ante investment.

OY is the Equilibrium level of output corresponding to point E.

In the table above the Equilibrium level of income ids Rs.400, when planned saving = planned
investment = Rs.40 crore.

If there is any deviation from the Equilibrium level of income i.e. if planned saving is not equal
to planned investment , then a process of readjustment will starts which bring the economy back
to Equilibrium level.
1. When planned saving is more than investment. It planned saving is more than planned
investment i.e. after point E (pt, a, b, c). It means that household are not consuming as
much as the firms expected then to. As a result, the inventory rises above desired level.
To , clear the unwanted increase in inventory , firms would plan to reduce the production till
saving and investment become equal to each other.
2. When saving is less than investment .It planned saving is less than planned investment .i.e.
before point E (pt,D,E,F)
It means that household are consuming more and saving less as companies expected them to
do.
As a result, the planned inventory would fall below the desired level. To bring the inventory
back. To the desired level, firms would plan to increase the production till saving and
investment become equal to each other.

Equilibrium level
Equilibrium level can be achieved at:
(i)
(ii)
(iii)

Full employment
Under employment level (less than full employment level)
Over full employment ( more than full employment level)

Full Employment Equilibrium: It refers to a situation when the aggregate demand is equal to the
aggregate supply at full employment level.
Diagram pending

I the above fig. E is full employment Equilibrium because aggregate demand EQ is equal to
full employment level of output OQ.
At OQ level of output , all those who are willing to work at the prevailing wage rate are able to
find employment .i.e. there is no involution unemployment

Under employment Equilibrium: - It refers to a situation when the aggregate demand is equal to the
aggregate supply when the resources are not fully employment. It occurs prior to the full employment
level.
In the fig AD=AS at point: F which is lower than full employment level.
Diagram pending

Over full employment Equilibrium: It refers to a situation AD=AS beyond the full employment level.
It occurs after the full employment level.

In fig. AD=AS at point G which is higher than full employment level.

Diagram pending

Point G signifies the over full employment Equilibrium

Short Run. Fixed price analysis of product market.

When aggregate supply is assumed constant Equilibrium is solely determined by aggregate

demand. (AD)
in the short run price take some time to respond to the forces of excess supply or demand as
producers try to update their production plans in the mean time.

So it is assumed that price remains constant in short run and vary in the long run.
In order to derive aggregate demand under fixed price of final goods (i.e. in the short run) it has to be
assumed that elasticity of supply is infinite is suppliers are willing to supply whatever amount
consumers will demand at and given constant price.