2.

Aggregate Demand and Its Components

Aggregate Demand

It is the total demand for all the goods and services produced in an economy in a
year. It represents the total expenditure on goods and services in the economy.

Components of Aggregate demand

1) Household Consumption Expenditure (C)

2) Firms’ Investment Expenditure (I)
3) Government Expenditure on goods and services (G)
4) Net Export (X-M)

Symbolically,
AD = C+I+G+(X-M)
In a 2 sector economy, AD=C+I
In a 3 sector economy, AD=C+I+G

Consumption demand and consumption function

Consumption demand is defined as the value of goods and services that

households are able and willing to buy at particular time. It depends first and
foremost on the level of income.
Keynes says that as income increases, consumption will increase. However,
increase in consumption will be less in proportion to increase in income. This
relationship between consumption and income is called consumption function or
propensity to consume. Consumption function may be represented by the
following equation.
_
C = C + bY where,
C = Consumption
_
C = Autonomous Consumption (Consumption where level of income is zero)
b = Marginal propensity to consume and
Y = Level of income

Marginal Propensity to Consume:

It is the ratio of change in consumption to a change in income. Symbolically,

MPC = ∆C
∆Y

Autonomous Consumption is the amount of consumption expenditure when

income is zero. Consumption is possible even where income is zero, because
there could be sale of assets, borrowings or current transfers. This act on the
part of households on final consumption is called dissavings.
The slope of consumption function is b (i.e.) MPC. It measures the rate of
change in consumption to change in income. MPC is always positive and its
value range between 0 and 1.

Aggregate Supply:
It refers to the value of total output in an economy in a year. It represents the
national income of the country during the given period.
AS = Y = C+S

AS curve is a 45o straight line starting from the origin. It is a 45o line because
consumption and savings are always equal to Y. The following table shows
consumption function given by C= 100 + 0.8Y
Consumption C Income Y MPC= C/ Y
100 -- 0 --- 0.8
180 80 100 100 0.8
260 80 200 100 0.8
340 80 300 100 0.8
420 80 400 100 0.8
500 80 500 100 0.8
580 80 600 100 0.8
660 80 700 100 0.8
740 80 800 100 0.8

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 820 80 900 100 0.8
900 80 1000 100 0.8

The following graph shows the consumption function

C = 100+0.8Y
The 45o line shows the income. It tells whether the consumption expenditure
is equal to or greater than or less than the level of income.

The consumption function crosses the 45o line at B which is known as break-
even-point. Here, the consumption is exactly equal to income. At that level of
income, the households are just breaking even. In the given example, the break-
even point of the economy is Rs.500 crore. To the left of B, consumption
expenditure is greater than income. The shortage in income compels the
households to go for Dissaving. The amount of dissaving or savings is always
measured by the vertical distance between consumption function and 45 o line.

Savings Function:
It refers to the ratio of level of saving to the level of income.
S=Y-C
Substituting the consumption function in the above equation.
_
S=Y-(C + bY)
= Y – C – bY
= - C + Y(1- b)

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Marginal Propensity to Save

It measures the increase in savings to an increase in income. The slope of

saving function is 1-b. Savings is an increasing function of income i.e. increase
in savings is more in proportion to increase in income.
MPS = 1-b = 1-MPC
This means that part of the increase in income which is not consumed, is saved.
Since income is either consumed or saved,
Y = C+S
Dividing the equation throughout by Y,
∆Y = ∆C + ∆S ; 1 = MPC + MPS
∆Y ∆Y ∆Y
Using the numerical example of consumption function, C=100+0.8Y is derived as

S = --C +(1—b)Y
= --100 + (1—0.8)Y
= --100 +0.2Y

Consumption and Savings function can be illustrated with the help of the
following table and diagram.

Y Y C C MPC S S MPS C+S MPC

+
MPS
0 -- 100 -- -- -100 -- -- 0 1
100 100 1800 80 0.8 -80 20 0.2 100 1
200 100 260 80 0.8 -60 20 0.2 200 1
300 100 340 80 0.8 -40 20 0.2 300 1
400 100 420 80 0.8 -20 20 0.2 400 1
500 100 500 80 0.8 0 20 0.2 500 1
600 100 580 80 0.8 20 20 0.2 600 1
700 100 660 80 0.8 40 20 0.2 700 1
800 100 740 80 0.8 60 20 0.2 800 1
900 100 820 80 0.8 80 20 0.2 900 1
1000 100 900 80 0.8 100 20 0.2 1000 1

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In the diagram, part A shows consumption function and part B shows saving
function. The break-even income is Rs.500 crores (part A) and savings is Rs.0
crore (part B).

Average Propensity to Consume and Save

Average Propensity to Consume gives the average of the relationship of
consumption and income at different levels of income. It is the ratio of
consumption to income at particular level of income.
APC = C/Y

Average Propensity to Save gives the average of the relationship between

savings and income at different levels of income. It is the ratio of saving to
income at particular level of income.
APS = S/Y
The following table shows that as income increases, the proportion of
income saved increases and the proportion of income consumed decreases.
Y C APC(C/Y) S APS(S/Y) APC+APS
000 100 0.00 -100 0.0 1
100 180 1.80 -80 -0.8 1
200 260 1.30 -60 -0.3 1
300 340 1.13 -40 -0.13 1
400 420 1.05 -20 -0.05 1
500 500 1.00 0 0.0 1
600 580 0.97 20 0.03 1
700 660 0.94 40 0.06 1
800 740 0.93 60 0.07 1
900 820 0.91 80 0.09 1
1000 900 0.9 100 0.1 1

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Investment: It is the second component of aggregate demand. It means addition
to the stock of capital goods in the form of equipment, residential structures and
inventory.

Two important roles of investment in macro economics are:

1) Change in investment is the main cause of fluctuations in aggregate demand
2) It helps economy to produce higher levels of output.

The three elements important to understand the level of investment in an

economy are:
1) Revenue: An investment will bring the firm additional revenue only if
investment enables the firm to sell more.
2) Cost: Two types of cost of investment are:
a) cost of equipment and structures and the cost incurred in their
maintenance.
b) Cost associated with funding of investment at the market rate of
interest.

3) Expectations: It is the entrepreneurial expectations of future and the level of

business confidence. Firms invest when they expect that their investment will be
profitable and revenues will be greater than the cost of investment.

Investment Demand Curve:

It shows the relationship between the investment demand and the rate of
interest. Marginal Efficiency of Capital the expected rate of return from an
additional investment. If MEC is greater than the market rate of interest, then
investment is profitable and vice versa.

Government Expenditure
It is the third component of aggregate demand. The level of government
expenditure is determined by the government policy.

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Net Exports
It is the fourth component of aggregate demand. It is the difference between
exports and imports. When foreigners purchase domestic goods and services, it
adds to the demand for domestic goods and services and is hence a part of
aggregate demand.
Correspondingly, our spending on foreign goods has to be subtracted from the
demand for domestic goods in order to get the net demand for domestic goods
and services by foreigners.