Economics CIA 3

Aggregate Demand and Aggregate

Supply
Aggregate Demand
• Components
• Consumption
• Investment
• Government Spending
• Net Exports

AD = C + I + G + NX
AD on Graphs

Notes on the Graph

• X Axis is Real
Output
• Y Axis is Price
Level
• A movement
along the D curve
will be caused by a
movement of the
Shifts of the AD Curve
 If any component
changes AD it will
cause a shift.
Should the
change be an
increase the curve
shifts to the right,
if it is a decrease
it shifts to the left
Determination of equilibrium
income and output.
• We will have to consider a two sector model.(the
household sector and the business sector)
• All the decisions concerning consumption
expenditure are taken by individual households
and business firms take decisions concerning
investment.
• We will also assume that consumption function is
linear and investment is autonomous.
Aggregate demand and
aggregate supply approach
• Equilibrium level is when aggregate demand
equals aggregate supply.
• Aggregate demand refers to the total
expenditure or total spending.
• Aggregate supply refers to the total output
of goods and services produced in an
economy.
• AS = Y = C + S
Introduction to Aggregate Supply

• Aggregate supply

Aggregate supply (AS) or Domestic Final Supply (DFS) is

the total supply of goods and services that firms in national
economy plan on selling during a definite time period.

Aggregate supply curve describes the relationship

between price levels and quantity of output that
firms are ready to provide
 Aggregate Supply Function
• Aggregate supply function

The aggregate supply can be defined as the total amount of money earnings
which the firms in the economy taken together ‘must receive’ from the sale of
their product at fluctuating levels of employment.

The aggregate supply price is positively related to the level of employment. It

increases with an increase in the level of implement and vice versa.

Thus, the aggregate supply schedule like the aggregate demand schedule, is
also an increasing function of the level of employment.

AS = f(N)

Where AS = aggregate supply price of the output, and

             N = number of workers employed.
Long run
• The long-run aggregate supply (LRAS) curve tells the level
of output produced by firms to the price level in the long
run.
• The long-run aggregate supply curve is a vertical line at
the economy’s probable level of output.
• In the long run, the economy can attain its natural level of
employment and potential output at any price level.
Short run
• During the short run, firms possess one fixed factor of
production (usually capital), and some factor input prices
are sticky.
• At low levels of demand, production can be increased
without diminishing returns and the average price level
does not rise.
• The short-run aggregate supply curve is an upward-sloping
curve that shows the quantity of total output that will be
produced at each price level in the short run.
 Greater than and lesser than
equilibrium
Lesser than-
If the output is Y2 which is lesser
than the equilibrium the planned
expenditure is more than
production level of OY2 by GH
amount.
This shows that there is more
demand than what they are
producing
This unplanned rise in demand
induces firms to increase
production and there by the income
also.
This brings back the AY2 line back
to AY0.
• Greater than -
 If the output is Y1 which is
greater than the equilibrium the
planned expenditure is less than
production level of OY1 by AB
amount.
 This shows that firms sell lesser
than that they are producing
( they are forced to add the unsold
stock to their inventories )
 This unplanned rise in inventories
induces firms to reduce
production and there by the
income also.
 This brings back the AY1 line
back to AY0
Investment Multiplier

• It is defined as the multiple amount of times income

increases as a result of increase in investment
expenditure.
• It is the ratio of change in income to the change in
investment.
• Thus K = ΔY / ΔI
• K- Investment multiplier
• ΔY and ΔI indicated change in income and change in
investment.
Graph Explained
• The initial equilibrium is at E0

• an increase in autonomous
investment expenditure ΔI shifts
the desired spending function
from AE0 to AE1

• The desired spending is now

more, therefore the income will
rise

• The new equilibrium is at E1

• Thus as a result of increase in

investment by ΔI the level of
income rises by Y0Y1 as we can
see the increase in income is
greater than increase in
Saving Investment Approach
• Intended Investment
• Intended Savings
• Actual Investment = Planned Investment + Unplanned
Investment
Explanation
When I>S

Reduction In Stock

Companies Produce More

Increase in Output , Income,

Employment

When S > I

Accumulation In Stock

Produce Less

Fall In Output , Income, Employment

Accelerator Model
■ T.N Carver was the earliest economist who recognized the
relationship between changes in consumption and net
investment in 1903.
■ Keynesian concept: Investment increase with the increase
in income by multiple amount
■ Accelerator model is quite opposite of Keynesian concept
■ The theory states that when income increases with the
increase in investment
■ Also can be defined as the ratio of change in capital stock
to the change in level of output
Mathematical Equation
■ To produce a given amount of output, it requires certain
amount of capital
■ If Y1 output is required to be produced and v is the capital
output ratio, the required amount of capital to produce Yt
will be given by the following equation :
Kt = vYt
Where, Kt stands for the stock of capital
Yt for the level of output or income,
v for capital-output ratio.
Mathematical Equation
■ Capital-output ratio v is equal to K/Y and in accelerator theory this ratio is
assumed to be constant

■ So when income is Yt then required stock of capital Kt = vYt when output

or income is equal to then required stock of capital will be Kt-1 = vYt-1.

■ It is evident from above that when income increases from Yt-1 in period t-
1 to Yt in period, t, then the stock of capital will increase from Kt-1 to Kt.

■ From above we can see that , Kt-1 is equal to vYt-1 and Kt is equal to
vYt.. Therefore, the increase in the stock of capital in period t is given by
the following equation: Kt – Kt-1 = vYt – vYt-1
 Effects of Money Supply on
AD and AS
• Transmission of Monetary Policy - Expansionary
 Central Bank shifts to a more expansionary Monetary Policy by
purchase of bonds to increase the money supply

 Diagram

 Shift in AD to its right (fall of real interest)

This Leads to
 a short-run increase in output

 a increase in the price level – Inflation

 Impact of a shift in monetary policy - interest rates, exchange rates,

and asset prices
Effects of Money Supply on AD
and AS
 Transmission of Monetary Policy – Contractionary

 Central Bank shifts to a more restrictive Monetary Policy by sale of

bonds to decrease the money supply

 Diagram

 Shift in AD to its left (rise of real interest)

 Purpose of Monetary Policy

If a change in monetary policy is timed poorly, it can

be a source of instability.
It can cause either recession or inflation.

Proper timing of monetary policy:

If expansionary effects occur during a recession
and restrictive effects during an inflationary
boom, the impact would be stabilizing.
Three ways that A.D and A.S
affect Indian Economy are :
1) National income

2) Household consumption expenditure

3) Business Circle
The Impacts On Indian Economy

• National Income
• Household Consumption Expenditure
• HFCE
• Business Circle
Monetary Tools used to
measure AD / AS
• Fiscal Policy to fight Inflation
• Monetary Policy and Bank Regulation
• Threat of Recession –
• Usage of Expansionary Fiscal Policy
• Increase In money supply, quantity of loans and
reduction of interest
• Shifts aggregate Demand curve to the right