Aggregate Demand and Aggregate Supply

Dr. B. MURUGESAN
Assistant Professor in Economics
Department of Humanities
National Institute of Technology
Tiruchirapalli-15
9789290047
ecomurugesan@gmail.com
John Maynard Keynes is considered to be the greatest
economist of the 20th century. He wrote several books.

However, his The General Theory of Employment,

Interest and Money (1936) won him everlasting fame
in economics.

The book revolutionized macro economic thought.

Keynesian economics is called the Keynesian
revolution.
 The central problem in macro economics is the
determination of income and employment of a nation
as a whole.

That is why modern economists also call macro

economics as the theory of income determination.

Keynes brings out all the important aspects of

income and employment determination and
Keynesian economics itself can be called macro
economics
 He attacked the classical economics and effectively
rejected the Says Law, the very foundation of the
classical theory.

He believed that in the short run, the level of income

of an economy depends on the level of employment.

The higher the level of employment, higher will be the

level of income.
A perusal of the basic ideas of Keynes can be clearly
understood from the brief summary in the flow chart.
Micro Demand Curve

The law of demand states that there is a

negative or inverse relationship between the
price and quantity demanded of a commodity
over a period of time.
Macro Aggregate Demand Curve
 Aggregate demand(AD)
Aggregate demand is the relationship between the
quantity of output demanded and the aggregate price
level.

In other words, the aggregate demand curve tells us

the quantity of goods and services people want to buy
at any given level of prices.
(or)
Aggregate Demand refers to the total value of final
goods and services which all the sectors of an
economy are planning to buy at a given level of
income during a period of one accounting year.
The Aggregate Demand Curve

The aggregate demand curve AD

shows the relationship between the
price level P and the quantity of
goods and services demanded Y.

It is drawn for a given value of

the money supply M. The aggregate
demand curve slopes downward:

the higher the price level P, the

lower the level of real balances M/P,
and therefore the lower the quantity
of goods and services demanded Y.
 Do not confuse Aggregate Demand with
Market Demand:

Aggregate Demand is the total demand for all goods

and services in the entire economy,

whereas, market demand is the total demand for one

commodity in the market.
 Components of Aggregate Demand

The various components of Aggregate demand are:

Private Investment Government Net

Consumption Expenditure Expenditure Exports
Expenditure (I) (G) (X-M)
(C)
 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 household on
purchase of goods and services during an accounting year.
2. Investment Expenditure(I):
It refers to the total expenditure incurred by all private firms on
capital goods.
3. Government Expenditure(G):
It refers to the total expenditure incurred by government on
consumer goods and capital goods to satisfy the common
needs of the economy.
4. Net Exports(X-M):
The difference between exports and imports is termed as net
exports.
 Components of Aggregate Demand

Private
Investment Government Net
Consumption
Expenditure Expenditure Exports
Expenditure
(C) (I) (G) (X-M)

AD = C+ I + G + (X-M)
 Shifts in the Aggregate Demand Curve

Changes in the money supply shift the aggregate demand

curve.
In panel (a), a decrease in the
money supply M reduces the
nominal value of output PY.

For any given price level P, output

Y is lower.

Thus, a decrease in the money

supply shifts the aggregate
demand curve inward from AD1 to
AD2.
In panel (b), an increase in the money supply M raises
the nominal value of output PY.

For any given price level P, output Y is higher.

Thus, an increase in the money supply shifts the

aggregate demand curve outward from AD1 to AD2.
 Aggregate supply (AS)

Aggregate supply is the relationship between the

quantity of goods and services supplied and the price
level.

Because the firms that supply goods and services

have flexible prices in the long run but sticky prices in
the short run, the aggregate supply relationship
depends on the time horizon.
 We need to discuss two different aggregate supply
curves:

The long-run aggregate supply curve LRAS and

The short-run aggregate supply curve SRAS.

We also need to discuss how the economy makes the

transition from the short run to the long run.
The Long-Run Aggregate Supply Curve
In the long run, the level of output is determined by the
amounts of capital and labor and by the available
technology;

it does not depend on the price level. The long-run

aggregate supply curve, LRAS, is vertical.
Shifts in Aggregate Demand in the Long Run
A reduction in the money supply shifts the aggregate
demand curve downward from AD1 to AD2.

The equilibrium for the economy moves from point A to

point B.
Because the aggregate supply curve is vertical in the
long run, the reduction in aggregate demand affects
the price level but not the level of output.
The Short-Run Aggregate Supply Curve

In this extreme example, all prices are fixed in the

short run.

Therefore, the short-run aggregate supply curve,

SRAS, is horizontal.
 Shifts in Aggregate Demand in the Short Run

A reduction in the money supply shifts the aggregate

demand curve downward from AD1 to AD2.
The equilibrium for the economy moves from point A to
point B.
Because the aggregate supply curve is horizontal in
the short run, the reduction in aggregate demand
reduces the level of output.
 From Short-run to Long run
Long-Run Equilibrium
In the long run, the economy finds itself at the
intersection of the long-run aggregate supply curve
and the aggregate demand curve.

Because prices have adjusted to this level, the short-

run aggregate supply curve crosses this point as well.
A Reduction in Aggregate Demand
The economy begins in long-run equilibrium at point A.

A reduction in aggregate demand, perhaps caused

by a decrease in the money supply, moves the
economy from point A to point B, where output is
below its natural level.

As prices fall, the economy gradually recovers from

the recession, moving from point B to point C.
Determination of Effective Demand

The principle of effective demand occupies a key

position in the Keynesian theory of employment.

Effective demand is the ability and willingness to

spend by individuals, firms and government. The level
of output produced and hence the level of
employment depends on the level of total spending in
the economy.
Keynes used aggregate demand and aggregate supply
approach to explain his simple theory of income
determination.

The term aggregate is used to describe any quantity

that is a grand total for the whole economy.
Aggregate demand is the total demand for all
commodities (goods and services) in the economy.
Aggregate supply is the total of commodities supplied
in the economy.
These two factors are called by Keynes as aggregate
demand function (ADF) and the aggregate supply
function (ASF).
 Aggregate demand is the total demand for all
commodities (goods and services) in the
economy.

Aggregate supply is the total of commodities

supplied in the economy.

These two factors are called by Keynes as

1. Aggregate Demand Function (ADF)

2. Aggregate Supply Function (ASF).
 Keynes made it clear that the level of employment
depends on aggregate demand and aggregate
supply.

The equilibrium level of income or output depends on

the relationship between the aggregate demand curve
and aggregate supply curve.

As Keynes was interested in the immediate problems

of the short run, he ignored the aggregate supply
function and focused on aggregate demand.

He attributed unemployment to deficiency in

aggregate demand.
Thank You