Aggregate Demand and Aggregate Supply

Lesson : Aggregate Demand and Aggregate Supply

Lesson Developers : ISHITA SACHDEVA

Research Analyst

Institute of Economic Growth

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 Aggregate Demand and Aggregate Supply

Learning Objectives

After reading the chapter, the students would be able to understand the
following:

 Concept of Aggregate Demand and Aggregate Supply.

 Keynesian and Classical Definition of Aggregate Supply.

 Synthesis between Aggregate Demand and Aggregate Supply.

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 Aggregate Demand and Aggregate Supply

1. INTRODUCTION

The Gross Domestic Product (GDP) of India is highlight of almost every

day newspapers, TV-channels, Parliamentary debates in the country.
Ever since the worldwide recession of 2008, the growth in GDP has
become a prime concern of the economic policies in the nation. The
trend in GDP for a period of nine years from 2004-13 is presented in
the following figure:

Graph: 1

GDP at 2004-05 Constant Prices (in Crores)

70,00,000

60,00,000

50,00,000

40,00,000
GDP at 2004-05 Constant Prices
30,00,000
(in Crores)
20,00,000

10,00,000

0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Source: Planning Commission

As can be seen from the graph, the GDP of India when measured at
constant prices has experienced a consistently increasing or a rising
trend. The upward slope of the GDP line is a mark of country’s sound
economic performance. However, when the trend of GDP growth rate

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 Aggregate Demand and Aggregate Supply

is observed, a different picture emerges which is given in the following

figure:

Graph: 2

GDP growth at constant 2004-05 prices

12

10

6 GDP growth at constant 2004-

05 prices
4

0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Source: Planning Commission

The GDP growth in India has experienced a cyclical pattern over the
nine year period with recording a major downward slump during 2008,
the period of recession that originated in the west attributed to the
sub-prime crises but left its impact on the world economies owing to
the forces of globalization and international trade. The downward trend
of the actual output of the trading nations of the west can be analyzed
from the macroeconomic tools of Aggregate Demand and Aggregate
Supply.

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 Aggregate Demand and Aggregate Supply

The tools of Aggregate Demand and Supply are widely used to explain
the fluctuations in the actual production across the economies. The
fluctuations in the output are usually accompanied by fluctuations in
the price level thereby causing inflation or deflation in the economy.
To understand how the tools can be utilized to understand the above
mentioned exercise, it is first essential to understand the basic
concepts of Aggregate Demand and Aggregate Supply.

2. Aggregate Demand

Aggregate Demand is the sum of quantities of goods and services

demanded by the households, investors, government and foreigners at
various prices, everything else remaining constant. In particular, it is
the sum of various individual demand curves that prevail in an
economy. Since, the aggregate demand curve is derived from the
individual demand curves; it holds the properties similar to it such as:

Prices and Aggregate Demand are negatively related for normal goods.

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 Aggregate Demand and Aggregate Supply

 A change in aggregate price level causes movement along the AD-

curve.

 A change is aggregate demand is characterized as a shift in the AD-

curve.

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 Aggregate Demand and Aggregate Supply

Source: courses.byui.edu

The downward slope of the demand curve depicts that the aggregate
spending by the economy declines at higher prices and also the
aggregate demand in the economy shows a rising trend with declining
prices. However, there are few effects at work that prompts the
demanders to behave in this manner. These effects are:

DID YOU KNOW???

Real Balance Effect is also

a. Real Balance Effect
known as PIGOU Effect. It
was named after Arthur
When the price level in the economy increases, it
Cecil Pigou by Don Patinkin
decreases the real value of the money held by the
in 1948.
public at large and thus reduces the purchasing
power of the money and other monetary wealth held in the form of
fixed assets such as bonds, shares etc. This makes the wealth owner

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 Aggregate Demand and Aggregate Supply

feel poorer than before and induces him to lower his spending. This is
called the Real Balanced Effect of a rise in the price level.

b. Rate of Interest Effect

Rising prices has its impact on the interest rate that governs the
Investment demand and Supply. When the aggregate price level in the
economy increases, the demand of money for making a given
transaction increases. With money supply held constant, a shift in the
aggregate demand raises the price of money that is interest rate.
Since Investment constitutes a major component of the aggregate
demand, the AD-curve slopes downward.

c. Foreign Trade Effect

Fluctuations in the general price level in the economy, affects the

import demands of the country. In the present era of globalization,
each nation trades with the other nation and thus imports and exports
make up a significant component of the aggregate demand. Thus when
price level in any nation declines; it makes the domestic goods
cheaper to the domestic and foreign buyers thereby increasing the
level of aggregate demand in the economy. The opposite effect occurs
when the domestic prices increases.

2.1 Derivation of Aggregate Demand

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 Aggregate Demand and Aggregate Supply

In a small closed economy, the aggregate demand is given by

the following equation:

AD = C + I + G; equation = 1

Where:

 AD is the aggregate or real spending by the economy.

 C depicts the consumption demand in the economy.
 I explain the investment demand.
 G indicates the demand by government for the domestic goods
and service.

However, in an economy which is indulged in the trade of goods

and services with the other nations in the world, another
component makes up the aggregate demand that is the
component of Net exports (NX). Thus, equation: 1 is modified to
include the component of net exports and appears as the
following:

AD = 𝑪 + I + G + NX equation = 2

Where NX = (X –M); with X representing the exports in the

economy while imports being indicated by M. Having explained
Aggregate demand in these terms only indicates the autonomous
components of AD; which are constant numbers and are not
driven or influenced by other economic factors. However, wide
fluctuations occur in the level of aggregate demands, induced by
the varying macroeconomic forces. Thus, it is desirable to

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 Aggregate Demand and Aggregate Supply

explain the induced components of the Aggregate demand.

Equation: 3 indicate a broader picture of the AD in any given
nation.

AD = 𝐶 + cYd + 𝐼 - bi + 𝐺 + 𝑁𝑋 equation = 3

Here, 𝐶 represents the autonomous component of consumption

demand.
c: is referred to as the proportion of induced consumption also
termed as marginal propensity to consume.
Yd: Disposable income level in the economy and is defined as (Y-
T).
𝐼 : Autonomous investment where as b indicates the induced
component of investment demand also referred to as marginal
propensity to invest.

The following section presents a graphical derivation of the

Aggregate demand curve:

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 Aggregate Demand and Aggregate Supply

As indicated in the diagram, the economy is initially at point A, which

is characterized by price level of $1.5 and the aggregate expenditure
of $ 2,000 billion. As the price level in the economy decreases from
$1.5 to $1, it causes an upward shift in the aggregate expenditure
curve leading to its intersection with the 45o line at point B in the
panel (a) of the diagram thereby increasing the level of aggregate
demand to $6,000 billion. Similar phenomenon occurs at point c in

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 Aggregate Demand and Aggregate Supply

panel (a and b). Joining these three aggregate price-output

combinations in panel b, we trace a downward sloping aggregate
demand for the nation.

2.2 Shifts in Aggregate Demand

At any given time, in an economy certain changes are taking place

making the nature of the economies dynamic. Factors comprising
aggregate demand and the fluctuations in it are the driving force
behind the level of aggregate output observed in an economy.
Expansionary fiscal policies through a surge in government
expenditure or a decline in the direct income tax has a positive effect
on the economy as it causes a rightward shift in the aggregate
demand curve thereby increasing the level of real output in the
economy at the same prices. The phenomenon is explained in the
following diagram:

Diagram

The economy is initially at operating at point A in panel a of the

diagram with the level or magnitude or government expenditure
indicated by G1. This leads to point a in panel b of the diagram that
corresponds to the price level of P1 and output Y1 and thereby to the
AD1 curve. An expansionary fiscal policy in the form of higher
government expenditure to G2 leads to a parallel shift of the Aggregate
Expenditure curve in panel a of the diagram. The economy is now
operating at point B which coincides with higher level of output
indicated by Y2. This point when mapped to the panel b of the diagram

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 Aggregate Demand and Aggregate Supply

leads to a new AD curve marked as AD2. The curve AD2 lies to the
right of the AD1 curve indicating the higher aggregate demand
prevailing in the economy at the existing price P1.

However a rightward shift of AD curve can also be explained by higher

Investment expenditure promoted by optimism of the business
community in the economic system or by expansionary monetary
policies which by reducing the cost of borrowing accelerates the level
of Investment and thereby the aggregate demand in the economy at
any given time.

3. Aggregate Supply

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 Aggregate Demand and Aggregate Supply

Aggregate Supply refers to all the goods and services that sellers in an
economy are willing to supply at a given price. The relation between
price and supply when considered at an individual or a microeconomic
level, then a linear positively sloped supply curve can be traced for a
major chunk of goods or services being supplied by the individual.

However, the nature of the aggregate supply curve is not that simple.
There are two schools of thought popularly called as Classicals and
Keynisians that promote the two differing slopes of aggregates supply
curve that can be observed for an economy.

The following diagram can be looked upon to gain a brief

understanding of the concepts of Aggregate Supply curve preached by
the two different schools.

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 Aggregate Demand and Aggregate Supply

As clearly indicated in the diagram, the Keynesian range explains a flat

or a horizontal aggregate supply curve. Keynes argued that economies
are characterized by unutilized resources. Thus increased output of
goods and services can be supplied at a given price. However, the
classical range lies at the other extreme which preaches a vertical
aggregates supply curve due to the classical belief of existence of the
conditions of full employment in an economy. As per the classical
school of thought, the economy is characterized by full employment of
resources and thus the level of aggregate supply is vertical
determining the potential of any economic system.

However, between these two extremes lies an intermediate AS curve

which is upward sloping and therefore indicates rising price level
associated with increasing output.

The Keynesian AS curve pertains to the short run supply behavior in

an economic system. In short run, which has no specific definition, but
is associated with low level of employment of the resources and idle

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 Aggregate Demand and Aggregate Supply

capacity of resources in the economy, any amount of increasing output

can be supplied at a given price as the idle resources are brought into
action without incurring any cost or rather incurring a very negligible
cost of employing these resources.

Classical AS curve corresponds to the long run where the potential of

the economy is reached as all idle resources from the short run are
now employed. Thus, the aggregate supply curve becomes vertical at
a level of aggregate output determined by the availability of all the
resources including manpower, machinery, raw materials etc.

3.1 Shifts in Aggregate Supply Curve

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 Aggregate Demand and Aggregate Supply

In terms of the intermediate range, the positive and adverse supply

shocks cause a rightward and a leftward shift of the Aggregate Supply
curve. The positive supply shocks can be identified in terms of
technological improvements that enhance the production and
consequently the supply of a given good or service, cheapening of the
raw materials. The positive supply shocks leads to a rightward shift of
the AS curve, (in diagram from AS1 to AS2 leading to a higher output
being supplied at a given price level. Similarly, an adverse supply
shock causing a leftward shift in the AS curve from AS1 to AS3 can be
associated with a higher staff salaries bargained by trade unions, poor
monsoon etc.

3.2 Interaction Between AS and AD

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Keynesian economics is also known as demand side economics since

Keynes highlighted the role Aggregate Demand could play for the
smooth functioning of the economy. DID YOU KNOW?

The Keynesian or the

demand side economics
emerged during the 1936 in
his book “The general
theory of Employment,
Interest and Money” during
the Great Depression.

Source: mmtwiki.org

Similarly, classical economics is also referred to as Supply side

economics for the significant role that the classical school of thought

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 Aggregate Demand and Aggregate Supply

believes AS play in an economic system. However, to understand the

functioning of the macro-economy, the role of neither of the two forces
can be denied.

Source: article.wn.com

Thus, it is crucial to understand the synthesis between these two

macroeconomic tools and its implications of variables such as GDP and
Aggregate Price level.

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 Aggregate Demand and Aggregate Supply

The interaction of the short run and demand curve in the above figure
coincides at Point A in the figure. Point A determines the output level Y
and price level P for the given economy. However let us now look at
point B, which is the point of lower price and output. Corresponding
point B, the Aggregate Demand is much higher than AS at price Pe.
Since, the demand is higher, the consumers are willing and able to bid
higher price for the existing goods and services. This increasing the
profit margin for the suppliers leads to a positive supply shock till the
movement at the two curves leads to their interaction at the point of
equilibrium i.e., point A.

Now, let us examine the AD or expansionary demand policy under

various AS scenarios.

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 Aggregate Demand and Aggregate Supply

To recall, the flat portion of the AS curve is the Keynesian Range.

Under the Keynesian range which is characterized by unemployed
resource, a rightward shift in the AD curve from AD1 to AD2 leads to a
higher level of real output being produced by the economy at the
original price level of P1.

Similarly, let us now consider point B which lies at the vertical portion
or Classical Range of the AS curve. The curve is vertical at full-
employment level of output as indicated by YFE. Under such scenario, if
a positive shift in the aggregate demand occurs here from AD3 to AD4,
then there only occurs a rise in price from P3 to P4 while the real output
in the economy remains at the full employment level that is YFE.

Let us now consider the rightward shift in the AD curve when there
also occurs shifts in the vertical AS curve which can occur only when
the overall resources in the economy increases and thereby expands

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 Aggregate Demand and Aggregate Supply

the output potential of the economy. It may occur if some potential

resource is extracted and is now being used as an actual resource or
some technical revolution occurs that leads to higher output being
produced with the available resources.

As depicted in the figure, a rightward shift in the LRAS curve to LRAS2

together with a positive demand shift from AD1 to AD2 leads to the real
national output of the economy expanding from Y1 to Y2 at the given
level of prices.

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 Aggregate Demand and Aggregate Supply

Exercises

Ques.1 Discuss the impact of contractionary fiscal policy (decline in

government expenditure) on inflation and real output of an economy in short
and long run?

Ques. 2 Calculate the equilibrium level of national income when

o C = 160 + 0.24 Y, 𝐼 = Rs.200 crores, 𝐺 = Rs. 250 crores

Ques.3 Discuss the features of short run and long run supply curve?

Ques.4 How does a technical revolution that enhances agricultural

productivity affects long run supply curve of the economy?

Ques.5 Derive the Aggregate Demand Curve using the Aggregate

Expenditure function and the 450 line? What causes AD curve to be
downward sloping?

Ques.6 The quantity of real GDP available for sale in the market at various
prices is depicted by the

I. Aggregate Demand Curve

II. Aggregate Supply Curve
III. Aggregate Expenditure Curve

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Ques.7 In the long run, at full employment level of aggregate supply, the
role of AD curve is to determine

I. real interest rate

II. price level
III. real output

Ques.8 An increase in autonomous taxes , causes AD curve to shift

I. Shift leftwards
II. Shift rightwards
III. No shift occurs

Ques.8 In long run, an increase in government expenditure raises

I. Real output
II. Prices
III. Real output and prices

Ques.9 In the Keynesian range of Aggregate Supply curve, an increase in

aggregate demand, raises

I. Real output
II. Price
III. Real output and prices

Ques.10 A rise in labor costs employed in coal industry, causes the price of
coal to,

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 Aggregate Demand and Aggregate Supply

I. Increase
II. Decrease
III. Remain the same

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References:

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