Aggregate Demand and

Aggregate Supply

Two Approaches to Macroeconomics

First, by classical economists
Other, by John Maynard Keynes

Classical Theory of Income and

Employment
An economy, as a whole always functions at the level
of full employment.
Supply creates its own demand
The whole of output is sold out (which implies that there is
no possibility of over-production and unemployment)
Equilibrium is established only at full employment.

Flexible system of prices, interest rates and wages

Price mechanism automatically brings equilibrium
between demand and supply
Flexibility of interest rates brings equality between savings
and investment
Flexibility of wage rates brings about full employment
equilibrium

Great Depression of 1930s

Industrialised western countries were
experiencing a fall in level of output, income
and employment.
Classicals could not explain the widespread
decline
It was against this background that Keynes
wrote the book General Theory of
Employment, Interest and Money

Criticisms against Classical Theory (By

Keynes)

In reality, an economy often doesnt function

at the level of full employment
Supply cannot create its equivalent demand
on its own
Prices, wages and interest may not be
flexible due to presence of monopolies,
trade unions, labour laws etc.

Keynesian Theory of Income and

Employment
An economy can be in equilibrium even at less
than full employment level.
Demand creates its own supply (Aggregate
demand directly determines the level of
output, income and employment)
Equilibrium level of income and employment
is determined by aggregate demand and
aggregate supply.

Assumptions of Keynesian Model

Price level is fixed.
Aggregate supply curve is flat and parallel to X
axis
Investment, Government expenditure, Taxes
and Net exports are autonomous.

Meaning of Aggregate Demand

Meaning Refers to the total demand for final
goods and services in the economy.
Alternatively,
It is the total amount of money which all
sectors (households, firms, government) of
the economy are ready to spend on purchase
of goods and services.

Components of Aggregate Demand

Aggregate demand (say AD) consists of planned
spending. In a four sector economy, it involves
expenditure
By households on consumption (i.e. Private Consumption
Demand) (say C)
By firms in capital goods (i.e. Private Investment Demand)
(say I)
By government in purchase of goods and services (i.e.
Government Demand for goods and services) (say G)
On net exports (say NX)

AD C I G NX

Consumption Demand and

Consumption Function
Consumption Demand refers to planned
consumption expenditure to be incurred by all
households on purchase of goods and services.
Consumption is a function of disposable income,

C f (Y )
The relationship between consumption and
income is called propensity to consume or
consumption function

Consumption Function (Contd.)

Generally, consumption demand increases
with the level of income
C C cY , C 0,0 c 1
Where C = Autonomous consumption at Y = 0
c = Marginal Propensity to consume

Aggregate Demand

AD

AD Y

AD0

AD A cY

C C cY

I
C

Y0
Income/ Output

Saving and Investment

In case of a two sector economy (i.e. there is no
government and no foreign trade), equilibrium exists
at the point where saving is equal to investment.

AD Y
C I C S
I S

Saving and Investment (Contd.)

Also, the difference between aggregate
demand and consumption is equal to planned
investment which is proved by the following
equations
AD C I G NX
Where G = 0, NX = 0
AD C I
AD C I

AD Y

AD

Aggregate Demand

Saving = Investment

AD0

I
C

AD C I
C C cY

B
(Break Even Point)

Y0
Income/ Output

Private Investment Demand

It refers to planned expenditure on creation of
new capital assets.
Investment is made not only to maintain
present level of production but also to
increase production capacity in future.
Elements which determine investment are:
Revenue (i.e. rate of return)
Costs (i.e. rate of interest)
Expectations (of profit)

Government Demand for Goods and

Services
It refers to planned government expenditure
on purchase of consumer and capital goods to
fulfill common needs of the society.
The level of government expenditure depends
upon government policy.
Government investment is guided by peoples
welfare motive

Net Exports
It reflects the demand of foreign countries for
our goods and services over our demand for
foreign countries goods and services.
Factors affecting net foreign demand are
Foreign exchange rates
Terms of trade
Trade policy of importing and exporting countries
Relative prices of goods
Types of exchange control

Aggregate demand function

By clubbing the four components of Aggregate
Demand along with taxes and transfer
payments, we derive the following function:
AD C I G NX
AD C cYD I G NX
AD C c(Y TA TR) I G NX
AD C c(TA TR) I G NX cY
AD A cY

Equilibrium Income and Output

I) Formula for Equilibrium Output
Equilibrium condition in goods market is that
the output is equal to aggregate demand:
Y AD
Y A cY
Solving for Y we get equilibrium level of
output where Y = Y0

A
Y0
1 c

Formula for Equilibrium Output

(Contd.)
When aggregate demand is not equal to output
there is either unplanned inventory investment or
disinvestment (say IU).

IU Y AD

If output is greater than aggregate demand, IU >

0. Firms reduce production until output is equal
to aggregate demand or IU = 0
If output is lesser than aggregate demand, IU < 0.
firms will increase production thus increasing
employment of resources until the two are equal.

Aggregate Demand

AD Y

AD

IU 0

AD0

AD A cY

E
IU 0

I G NX

A
C C c(TA TR ) cY

C c(TA TR )

Y0
Income/ Output

Graphical Representation of Equilibrium

The 45 line, AD = Y shows points at which output
and aggregate demand are equal
At point E, planned spending precisely matches
production
The arrows in the figure indicate how the
economy reaches equilibrium level of income
(Y0).
If Y < Y0 , AD > Y, IU < 0
If Y > Y0 , AD < Y, IU > 0

Why the Aggregate Demand Curve

Might Shift?
Shifts arising from Consumption
Shifts arising from Investment
Shifts arising from Government
Purchases
Shifts arising from Net Exports

How much does a Re. 1 increase

in autonomous spending raise
the equilibrium level of income?

The Multiplier
The answer to previous question appears to
be simple. A Re. 1 increase will increase the
income by Re. 1? The answer is wrong.
Suppose first that output is increased by Re. 1
to match the increased level of autonomous
spending
It will give further rise to induced spending.
Out of that additional rupee of income, a
fraction c is consumed.

The Multiplier (Contd.)

To meet this induced expenditure income
increases by 1 + c
But at this point excess demand will exist, so the
process will go on.
Production expands by A . This increase in
production gives an equal increase in income and
thus via c it gives rise in second round of
increased expenditure of size c A .
This gives rise in third round of increased
expenditure of size c 2 A .

The Multiplier (Contd.)

ROUND

INCREASE IN
DEMAND

INCREASE IN
PRODUCTION

CUMULATIVE INCREASE
IN INCOME

c A

c A

(1 c) A

c2 A

c2 A

(1 c c 2 ) A

c 3 A

c 3 A

(1 c c 2 c 3 ) A

1
A
1 c

The Multiplier (Contd.)

AD A c A c A c A .......
2

AD A(1 c c c .......)
2

1
AD
A Y0
1 c
The multiplier is denoted by

1 c
The larger the marginal propensity to consume, the
larger is the multiplier

AD Y

AD
E'

Aggregate Demand

AD0
AG
A

'

1
A
1 c

Y0

Y0 Y

'

Y0

Income/ Output

'

AD A cY
'

'

AD A cY

Tax Multiplier
Change in equilibrium income will equal the
change in aggregate demand.

Y0 c(Y0 TA)
(1 c)Y0 cTA
c
Y0
TA
1 c

The Government Sector

Government directly affects equilibrium income in
two ways:
Government purchases of Goods and Services (G)
Taxes and Transfer payments (TA and TR) which affect the
relationship between output and disposable income (YD)

AD C I G NX
AD C cYD I G NX
AD C cTR c (1 t )Y I G NX
AD C cTR I G NX c (1 t )Y
AD A c (1 t )Y

Effects of a Change in Fiscal Policy

Its impact can be measured with the help of
multiplier while including the effect of taxes
Change in equilibrium income will equal the
change in aggregate demand. This implies,
Y0 AD0 G c(1 t )Y0
1
Y0
G G G
1 c(1 t )
1
Where , G
1 c(1 t )

AD Y

Aggregate Demand

AD
E'

AD0
A

'

AD A c(1 t )Y
'

'

AD A c(1 t )Y

E
Y0

Y0

Y0

Income/ Output

'

Transfer Payment Multiplier

Change in equilibrium income will equal the
change in aggregate demand.

Y0 c(Y0 TR)
(1 c)Y0 cTR
c
Y0
TR
1 c

Effects of Government Purchases and

Tax Changes on the Budget Surplus
The Budget surplus is the excess of
governments revenues (mainly taxes) over its
total expenditures.

BS TA G TR
Or
BS tY G TR

Effects of Government Purchases and Tax

Changes on the Budget Surplus (Contd.)
BS tY0 G
BS t G G G

t
BS
1 G
1 c(1 t )

(1 c)(1 t )
BS
G

1 c(1 t )

Balanced Budget Multiplier

This helps us to answer an important question: If
taxes and spending are raised by equal amounts, by
how much will the output increase?
Here,
TA G

Then, Y0 c(Y0 TA) G

Y0 cY0 cTA G
(1 c)Y0 G cG
(1 c)Y0 (1 c)G
Y0 G

Full Employment Budget Surplus

It measures surplus at the full employment
level of income or at potential output.

BS tY G TR
*

Where, Y* = Full employment level of income

The difference between actual and full
employment budget surplus is just because of
proportional taxes
BS * BS t (Y * Y )

Full Employment Budget Surplus (Contd.)

If output is below full employment, the full
employment surplus exceeds actual surplus.
If actual output exceeds full employment
output, the full employment surplus is less
than the actual surplus.

Meaning of Aggregate Supply

It is the money value of total output available
in the economy for purchase during a given
period.

Contradiction to Classical Model

In reality, the rate of unemployment
fluctuates far more than is consistent with the
view that all unemployment is frictional.
There appears to be a systematic relationship
between the rate of change of wages and
unemployment contrary to the belief that
wages are determined by productivityand the
impact of money on prices, not at all by
unemployment.

The Phillips Curve

In 1958, A.W. Phillips published a
comprehensive study of wage behaviour in UK
for the years 1861 1957.

The Phillips Curve (Contd.)

The Phillips Curve is an inverse relationship
between the rate of unemployment and the
rate of increase in money wages i.e.
The higher the rate of unemployment, the lower is
the rate of wage inflation

The curve shows that the rate of wage

inflation decreases with the unemployment
rate.

Derivation of Equation of Phillips Curve

Let W be the wage this period and W-1 the
wage last period, the rate of wage inflation, gw,
is defined as
W W1
gw
W1

With u* representing the natural rate of

unemployment we can write the Phillips curve
as
g w (u u*)

Derivation of Phillips Curve and

Implications
From the two previous equations, we get the
following equation for the Phillips curve
W W1[1 (u u*)]
The curve suggests that wages and prices are
slow to adjust with respect to aggregate demand.
This is because of the fact that the wages are
inversely related to unemployment rate.
A change in wage rate requires a change in
unemployment rate in the opposite direction.

Success of the Phillips Curve

The curve became indispensably important
when it came to macroeconomic policy
analysis.
During the 1960s and 70s, it was common
practice for governments around the world to
select a rate of inflation they wished to
achieve, and then expand or contract the
economy to obtain this target rate.

Does the Phillips Curve Still Hold True?

The curve didnt hold up well in 1960s, either
in Britain or in the United States.
Many economists argued that the curve was
too simple as the curve couldnt fit the data
related to 1970s and 1980s.
Between 1993 and 2008, unemployment fell
to record lows, but inflation did not rise, as
predicted by the Phillips curve.

What is Wage Stickiness?

When wages move slowly over time rather
than being fully and immediately flexible, so
as to ensure full employment at every point in
time then such a situation is known as Wage
Stickiness.

What is Wage Stickiness? (Contd.)

Wages are typically an inflexible production
cost because nominal wages are determined
by contracts that were signed some time
ago.
Companies are also reluctant to change
wages in response to economic conditions.

What is Wage Stickiness? (Contd.)

Producers wont lower wages in times of an
economic downturn (unless it is particularly
long and severe) for fear of creating worker
resentment.
Producers wont raise wages during good
economic times (until they are at risk of
losing employees to competitors) as they
wont want to encourage them to routinely
demand higher wages.

Why are Wages Sticky?

Phillips curve equation in terms of relationship
between wage rate and level of employment is
given by

N N *
W W1 1

N *

If N (actual labour force) = N* (full employment

labour force), W = W-1
If N > N*, W > W-1
If N < N*, W < W-1

Why are Wages Sticky? (Contd.)

The Phillips curve also suggests that the curve
shown shifts over a period of time
In case of over-employment in this period, the
WN curve will shift to WN in next period.
In case of less than full employment in this
period, the WN curve will shift to WN in next
period
Thus, changes in aggregate demand that alter
rate of unemployment will have effects on wages
in subsequent periods.

WN '

Wage rate

WN
WN ' '

W1

N*
Employment

Derivation of Aggregate Supply Curve

I) The Production Function
Y aN

Where, Y = Output, a = labour productivity and

N = labour input
Eg Lets assume that N is expressed in hours
and a = 3. If a worker produces a unit of
output in 2 hours, then total output will be Y
= 3x2 = 6

Derivation of Aggregate Supply Curve (Contd.)

II) Costs and Prices
Next step is to link firms prices with their costs. The
principle here is that a firm will supply its output
to at least cover its costs.
Let W/a be the labour cost of production per unit of
output (eg, wage rate is Rs. 15 per hour and a is
3, then labour cost per unit is Rs. 5). Let z be the
profit margin on labour costs. Then price P is
given by:

(1 z )W
P
a

Derivation of Aggregate Supply Curve (Contd.)

III) The Phillips Curve
The equation of the Phillips Curve is as given
below:

N N *
W W1 1

N *

Multiplying both sides by (1 z) , we get

a

(1 z )
N N *
P
W1 1

a
N *

Derivation of Aggregate Supply Curve (Contd.)

N N *
P P1 1

N *

From the production function we know that:

Y
N
a

Thus, the equation on the top can be written as

Y Y *
P P1 1

Y *

P P1 1 (Y Y *)

AS '

AS

Price rate

AS' '

Y*
Output

Shifts Of The Short Run

Aggregate Supply Curve
There are three important factors that affect
producers profit per unit and shifts in the
SRAS curve:
1. Changes in commodity prices
2. Changes in nominal wages
3. Changes in productivity

Assumptions of Aggregate Supply

Curve
The markup z is constant
Output is proportional to employment

Properties of Aggregate Supply Curve

The flatter the AS curve, smaller is the impact
of output and employment changes on
current wages.
The position of AS curve depends on the past
level of prices.
The AS curve shifts over time. If output is
maintained above the full employment level,
Y*, then over time wages continue to rise
which are passed on into the prices.

AS' '

E' ' '

AS '

Price rate

E' '

P'

AS

E'
E
Short Term

AD'

AD
Y*
Output

Thank You