Aggregate Demand

and Aggregate Supply

Dr. M Manjunath Shettigar

Objectives
Understand and define aggregate
demand
Know the components of Aggregate
Demand
Which are the determinants of Aggregate
Demand?
What is consumption?
What is investment?
What is Savings?
Understand the relationship between
Consumption, Savings and Investment
Meaning and types of Government
spending

Aggregate Demand

Defined:
Amounts of Real Output
Buyers Collectively Demand
At Each Possible Price Level
 Aggregate Demand

Is the total level of demand for desired goods

and services (at any time by all groups within
a national economy) that makes up the gross
domestic product (GDP)
It is a sum of consumption expenditure,
investment expenditure, government
expenditure and net exports
Other things equal, the amount people and
institutions (consumers) are willing to buy at
a given price level
Total demand for goods and services for a
given price level
 AD
Aggregate Demand Curve
P

AD
Y

5
AD
Reasons for downward slope of AD curve

Wealth effect
P Real income/wealth AD
Interest rete effect
P Interest rete AD
Foreign trade effect
P NX AD
 AD
Other factors (factors other than Price
level) that influence Aggregate Demand
Level of income/ wealth
The rate of interest
Tax rate
Government policy
Economic conditions in other countries
Business confidence/ sentiments
Natural factors/ rainfall
AD
Other factors (factors other than Price
level) that influence Aggregate Demand

Change in these factors favourable and

unfavourable caused shift in AD curve

Favourable changes lead to rightward shift

and unfavourable changes lead to leftward
shift

This is shown in the diagram in the next

slide:
 AD

aggregate demand curve

AD1

AD
AD2

Y
9
 Components of Aggregate
Demand
Consumption Demand (Consumption of goods
and services by the private sector- C )
Investment Demand (Investment by the
private sector-I )
Government expenditure (C and I by
Government - G)
Net Exports ( C and I by external sector (X)
minus Imports (M)
Y = C+ I + G + X M
Actual GDP = Aggregate Demand
It is the aggregate spending by the private
sector, Govt. sector and net external sector on
consumption and investment goods and
 Aggregate Demand is thus up made of

Private Sector spending

Government sector spending
External sector spending
DETERMINANTS OF AGGREGATE
DEMAND
1. Consumer Spending
2. Investment Spending
3. Government Spending
4. Net Export Spending
 1. Consumption Demand

Aggregate expenditure on Current

Consumption of final goods and services.
Expressed as a positive relation between
Aggregate Consumption and Disposable
Income
Consumption expenditure is the
dominant component of aggregate
demand
Consumption demand

DISPOSABLE INCOME:
Divided into
Consumption
Savings
 Components of consumption

Non-durable goods likes of food, drink, cloth,

lighting, heating, entertainment, etc.
( Consumable goods )

Durable goods likes of furniture, appliances,

cars, scooters, air-conditioners, jewelry, etc.

Services all non-durables consisting of hair

cut, laundry, transport, banking, insurance,
health, education, legal and other services
Determinants of consumption

Income
Wealth
Interest rate
Tax rates
Credit availability
Consumers expectations
Consumer Indebtedness
Income/wealth distribution
Fluctuations in Consumption
demand
Due to

Changes in the above

factors
Keyness Theory of
Consumption Function

The concept of Consumption Function is

an important contribution of Keynes to
macroeconomics.
Consumption function refers to the
functional relationship between
consumption expenditure and national
income at different levels.
 The Keynesian Theory of
Consumption
Keynesian Consumption Curve is shown in terms of an equation as below:

C = a + bY

FIGURE - An Aggregate
Consumption Function

The aggregate consumption

function shows the level of
aggregate consumption at
each level of aggregate
income.

The upward slope indicates

that higher levels of income
lead to higher levels of
consumption spending.
APC & MPC
 On the other hand, marginal propensity to consume (MPC)
is the additional consumption expenditure (C) out of the
additional income (Y). In other words, marginal
propensity to consume refers to the ratio between change
in consumption expenditure and change in income which
causes it. Marginal propensity to consume can be
expressed in symbols as below:

Where, MPC = Marginal Propensity to Consume, C =

Change in Consumption, and Y = Change in Income.
 According to Keynes, consumption expenditure
increases along with increase in national
income, but it increases less than
proportionately.
This is known as the Psychological Law of
Consumption.
It is obvious that when income is low, people
spend all or a large part of it on consumption.
In other words, they save less. However, as
income increases people spend less and less on
consumption, and make more and more
savings.
It should be noted that the absolute
expenditure on consumption increases with
increase in income. It is only the proportion of
income spent on consumption that goes on
diminishsing with increase in consumption.
 For e.g. when income is Rs 1000, people
may spend Rs 900 on consumption. This
is 90% of income. But when income
increases to Rs 2000 the expenditure on
consumption may be Rs 1600. This is only
80% of income. Thus even though
absolute expenditure on consumption is
more now, as proportion of income it is
only 80% compared to 90% earlier.
 2. Investment Demand
Investment means expenditure on building new
capital goods.
Aggregate Investment Expenditure is for
purchase of new assets which will help in
production of future goods and services.
Purchase new machinery
Expenditure on setting up of new plant
In addition, expenditure on purchase of new
housing units is also considered investment

Investment for the economy means spending

on
physical capital, not financial assets (Equity
and Debt)
Capital Stock

Total quantity of industrial plants, capital

equipment, machinery, residential
housing units, etc. at a given point of
time.

Investment is the change in capital stock

over a period of time

Investment is a flow, while capital is a

stock
Importance of investment demand

Investment expenditure has a dual role -

Like consumption expenditure, it creates
new demand, leading to an increase in the
Aggregate Demand
In addition, Investment adds to the
productive capacity, thereby enhancing the
Aggregate Supply (AS)
Gross Investment & Net
Investment

Net Investment = Gross Investment -

Depreciation
Acceleration Principle

An economic concept that draws a

connection between output and
capital investment.

According to the acceleration principle, if

demand for consumer goods increases,
then the percentage change in the demand
for machines and other investment
necessary to make these goods will
increase even more (and vice versa).

In other words, if income increases, there

will be a corresponding but magnified
change in investment (via increase in
The acceleration principle can be
expressed in the form of the
following equation:
I = v (Yt Yt-1)
I = v Yt
where I is investment in period t, v is the
accelerator, Yt is the national output in
period t, and Yt-1 is the national output in
the previous period (t -1).
The equation tells that investment during
period t depends on the change in output
(Y) from period t - 1 to period t multiplied
by the accelerator (v)
If Yt > Yt-1 net investment is positive during
period t. On the other hand, if Yt < Yt-1 net
 Importance of investment demand

Subject to wider fluctuations and hence

more volatile than consumption demand.
Affects production capacity and thus the
long term growth potential of the economy.
Investments positively affects both AD and
AS
Components of Investments
Fixed non-residential(business)
investments
Inventory Investments
Fixed Residential Investments
Induced investment and autonomous
investment
Business investment can be divided into:
(1) expenditures which are undertaken by
the business sector regardless of the
economic conditions Autonomous

(2) Changes in investment expenditure that

results because of changes in market/
demand conditions - Induced

32
Determinants of Aggregate Investment
Expenditure
Interest rate more investments so long
as return from the investment exceeds
cost (interest rate)
Expected rate of profit (MEC)
Planned output net investment is
governed positively by the change in
expected output
Wage rate investment depends
positively on the wage rate (this factor is
relevant in the long run)
Tax laws
Availability of capital
Technology development
Business confidence/stock market
behaviour
 Savings and Investment
linkage
Saving is consumption forgone - If savings
rise, consumption will fall.
Level of saving in the economy, like
consumption, depends basically on income.
Saving is inevitable for capital formation and
economic growth.
Saving itself has nothing to do with
economic growth unless properly mobilized
and effectively channelized and invested to
enhance capital stock to increase production
and wealth of the economy.
Savings form the backbone for investments
viz., higher savings lead to higher
investments and vice versa
Savings and Investment
linkage
We can speak of 4 sources of savings:

Household sector savings (Id C)

Business sector savings (R (Oc + Dp))
Government sector savings (T- G)
Foreign savings (M-X)
Investment, Savings, and Foreign
Borrowing
Gross product = C + I + G + (X M).

Interestingly, gross product also equals

gross income, which necessarily equals the
sum of consumption (C), private savings (S),
and taxes (T), since all income must
ultimately be used in one of these three
ways.
So, Gross income = C + S + T

As a result, we can say that

C + I + G + (X M) = C + S + T
Investment, Savings, and Foreign
Borrowing
Some simple manipulation produces the
following identity regarding the sources of
investment:

I = S + (T G) + (M X),

Where,

S is domestic private sector savings,

T G (the government budget surplus)
reflects government savings, and
M X (net imports) reflects foreign
borrowing, since any excess of imports over
exports can only be funded through
Investment, Savings, and Foreign
Borrowing
What this tells us is that investment is
funded out of these three basic sources:
private savings (personal savings plus the
retained earnings of firms), government
savings (the government budget surplus), and
borrowing from abroad (net imports).
If a nation wishes to increase its level of
investment, it must either reduce its
private consumption (to increase private
savings), reduce its government spending
or raise taxes (to increase government
savings), increase its foreign borrowing,
or perhaps do some combination of all of
these.
 3. Government
expenditure
Government expenditure is spending by the
public sector, i.e., expenditure by the central,
state and local government and any loans or
grants to the nationalized industries.

Also known as Government spending.

Mainly three types :

government consumption
government investment
transfer payments
 Government consumption: Government
purchases of goods and services for current
use
It includes Govt. spending on purchase of goods and
services-stationary, medicines, uniforms for Govt.
hospitals, payment for services provided by Govt.
servants like police, defense, other Govt.
ministries, and so on
Government investment: Government
purchases of goods and services intended to
create future benefits
Eg: Infrastructure investment, setting up public
sector enterprises, research spending and so on
Transfer payments: Government
expenditures that just represent transfers of
money.
They are just transferred from one section of the
society (tax payers) to another section(who
need it) without adding to production. (and
 4. Net Exports (X - M)
Net Exports Is a component of the total
expenditure (Aggregate Demand)
Is the value of a country's total exports
minus the value of its total imports.
It is used to calculate a country's aggregate
expenditures, or GDP, in an open economy.
It is the amount by which foreign spending
on a home country's goods and services (our
exports) exceeds the home country's
spending on foreign goods and services (our
imports).
For example, if foreigners buy $200 billion worth of U.S.
exports and Americans buy $150 billion worth of
foreign imports in a given year, net exports would be
positive $50 billion.
 It represents the net foreign demand for
domestic goods and services and an
increase in this will lead to an increase
AD and vice versa.

It affects production, employment and

inflation in a country, among other
important macro variables.
 Net exports of goods and services equals
the difference between domestic saving
and investment.
Accordingly if a country saves more than
it invests it has a positive net exports
On the contrary, if a country is investing
more than its savings it has a negative
net exports
It implies that the determinants of net
exports are same as those of domestic
savings and investment :
(I S) = Net Foreign Investment
= Net Capital Inflow
2 main determinants of Net
Exports

1. Economic conditions abroad

2. Exchange Rate