Aggregate Demand and Aggregate Supply

Lesson : Aggregate Demand and Aggregate Supply Lesson Developers : ISHITA SACHDEVA Research Analyst Institute of Economic Growth

Institute of Lifelong Learning, University of Delhi

Aggregate Demand and Aggregate Supply

Learning Objectives

After reading the chapter, the students would be able to understand the following:

 Concept of Aggregate Demand and Aggregate Supply.  Keynesian and Classical Definition of Aggregate Supply.  Synthesis between Aggregate Demand and Aggregate Supply.

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Aggregate Demand and Aggregate Supply

1. INTRODUCTION

The Gross Domestic Product (GDP) of India is highlight of almost every day newspapers, TV-channels, Parliamentary debates in the country. Ever since the worldwide recession of 2008, the growth in GDP has become a prime concern of the economic policies in the nation. The trend in GDP for a period of nine years from 2004-13 is presented in the following figure:

Graph: 1

GDP at 2004-05 Constant Prices (in Crores) 70,00,000 60,00,000 50,00,000 40,00,000 GDP at 2004-05 Constant Prices (in Crores)

30,00,000 20,00,000 10,00,000 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Source: Planning Commission As can be seen from the graph, the GDP of India when measured at constant prices has experienced a consistently increasing or a rising trend. The upward slope of the GDP line is a mark of country’s sound economic performance. However, when the trend of GDP growth rate

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Aggregate Demand and Aggregate Supply is observed, a different picture emerges which is given in the following figure:

Graph: 2

GDP growth at constant 2004-05 prices 12 10 8 6

GDP growth at constant 200405 prices

4 2 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Source: Planning Commission

The GDP growth in India has experienced a cyclical pattern over the nine year period with recording a major downward slump during 2008, the period of recession that originated in the west attributed to the sub-prime crises but left its impact on the world economies owing to the forces of globalization and international trade. The downward trend of the actual output of the trading nations of the west can be analyzed from the macroeconomic tools of Aggregate Demand and Aggregate Supply.

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Aggregate Demand and Aggregate Supply The tools of Aggregate Demand and Supply are widely used to explain the fluctuations in the actual production across the economies. The fluctuations in the output are usually accompanied by fluctuations in the price level thereby causing inflation or deflation in the economy. To understand how the tools can be utilized to understand the above mentioned exercise, it is first essential to understand the basic concepts of Aggregate Demand and Aggregate Supply.

2. Aggregate Demand

Aggregate Demand is the sum of quantities of goods and services demanded by the households, investors, government and foreigners at various prices, everything else remaining constant. In particular, it is the sum of various individual demand curves that prevail in an economy. Since, the aggregate demand curve is derived from the individual demand curves; it holds the properties similar to it such as:

Prices and Aggregate Demand are negatively related for normal goods.

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Aggregate Demand and Aggregate Supply

 A change in aggregate price level causes movement along the ADcurve.

 A change is aggregate demand is characterized as a shift in the ADcurve. Institute of Lifelong Learning, University of Delhi

Aggregate Demand and Aggregate Supply

Source: courses.byui.edu The downward slope of the demand curve depicts that the aggregate spending by the economy declines at higher prices and also the aggregate demand in the economy shows a rising trend with declining prices. However, there are few effects at work that prompts the demanders to behave in this manner. These effects are:

DID YOU KNOW???

a. Real Balance Effect When the price level in the economy increases, it decreases the real value of the money held by the

Real Balance Effect is also known as PIGOU Effect. It was

named

after

Cecil Pigou by Don Patinkin in 1948.

public at large and thus reduces the purchasing power of the money and other monetary wealth held in the form of fixed assets such as bonds, shares etc. This makes the wealth owner Institute of Lifelong Learning, University of Delhi

Arthur

Aggregate Demand and Aggregate Supply feel poorer than before and induces him to lower his spending. This is called the Real Balanced Effect of a rise in the price level.

b. Rate of Interest Effect Rising prices has its impact on the interest rate that governs the Investment demand and Supply. When the aggregate price level in the economy increases, the demand of money for making a given transaction increases. With money supply held constant, a shift in the aggregate demand raises the price of money that is interest rate. Since Investment constitutes a major component of the aggregate demand, the AD-curve slopes downward.

c. Foreign Trade Effect Fluctuations in the general price level in the economy, affects the import demands of the country. In the present era of globalization, each nation trades with the other nation and thus imports and exports make up a significant component of the aggregate demand. Thus when price level in any nation declines; it makes the domestic goods cheaper to the domestic and foreign buyers thereby increasing the level of aggregate demand in the economy. The opposite effect occurs when the domestic prices increases.

2.1 Derivation of Aggregate Demand

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Aggregate Demand and Aggregate Supply In a small closed economy, the aggregate demand is given by the following equation:

AD = C + I + G;

equation = 1

Where: 

AD is the aggregate or real spending by the economy.



C depicts the consumption demand in the economy.



I explain the investment demand.



G indicates the demand by government for the domestic goods and service. However, in an economy which is indulged in the trade of goods and services with the other nations in the world, another component makes up the aggregate demand that is the component of Net exports (NX). Thus, equation: 1 is modified to include the component of net exports and appears as the following:

AD = 𝑪 + I + G + NX

equation = 2

Where NX = (X –M); with X representing the exports in the economy while imports being indicated by M. Having explained Aggregate demand in these terms only indicates the autonomous components of AD; which are constant numbers and are not driven or influenced by other economic factors. However, wide fluctuations occur in the level of aggregate demands, induced by the varying macroeconomic forces. Thus, it is desirable to Institute of Lifelong Learning, University of Delhi

Aggregate Demand and Aggregate Supply explain the induced components of the Aggregate demand. Equation: 3 indicate a broader picture of the AD in any given nation.

AD = 𝐶 + cYd + 𝐼 - bi + 𝐺 + 𝑁𝑋

equation = 3

Here, 𝐶 represents the autonomous component of consumption demand. c: is referred to as the proportion of induced consumption also termed as marginal propensity to consume. Yd: Disposable income level in the economy and is defined as (YT).

𝐼 : Autonomous investment where as b indicates the induced component of investment demand also referred to as marginal propensity to invest. The following section presents a graphical derivation of the Aggregate demand curve:

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Aggregate Demand and Aggregate Supply

As indicated in the diagram, the economy is initially at point A, which is characterized by price level of $1.5 and the aggregate expenditure of $ 2,000 billion. As the price level in the economy decreases from $1.5 to $1, it causes an upward shift in the aggregate expenditure curve leading to its intersection with the 45o line at point B in the panel (a) of the diagram thereby increasing the level of aggregate demand to $6,000 billion. Similar phenomenon occurs at point c in Institute of Lifelong Learning, University of Delhi

Aggregate Demand and Aggregate Supply panel

(a

and

b).

Joining

these

three

aggregate

price-output

combinations in panel b, we trace a downward sloping aggregate demand for the nation.

2.2 Shifts in Aggregate Demand

At any given time, in an economy certain changes are taking place making the nature of the economies dynamic. Factors comprising aggregate demand and the fluctuations in it are the driving force behind the level of aggregate output observed in an economy. Expansionary

fiscal

policies

through

a

surge

in

government

expenditure or a decline in the direct income tax has a positive effect on the economy as it causes a rightward shift in the aggregate demand curve thereby increasing the level of real output in the economy at the same prices. The phenomenon is explained in the following diagram: Diagram The economy is initially at operating at point A in panel a of the diagram with the level or magnitude or government expenditure indicated by G1. This leads to point a in panel b of the diagram that corresponds to the price level of P1 and output Y1 and thereby to the AD1 curve. An expansionary fiscal policy in the form of higher government expenditure to G2 leads to a parallel shift of the Aggregate Expenditure curve in panel a of the diagram. The economy is now operating at point B which coincides with higher level of output indicated by Y2. This point when mapped to the panel b of the diagram Institute of Lifelong Learning, University of Delhi

Aggregate Demand and Aggregate Supply leads to a new AD curve marked as AD2. The curve AD2 lies to the right of the AD1 curve indicating the higher aggregate demand prevailing in the economy at the existing price P1.

However a rightward shift of AD curve can also be explained by higher Investment expenditure promoted by optimism of the business community in the economic system or by expansionary monetary policies which by reducing the cost of borrowing accelerates the level of Investment and thereby the aggregate demand in the economy at any given time.

3. Aggregate Supply

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Aggregate Demand and Aggregate Supply Aggregate Supply refers to all the goods and services that sellers in an economy are willing to supply at a given price. The relation between price and supply when considered at an individual or a microeconomic level, then a linear positively sloped supply curve can be traced for a major chunk of goods or services being supplied by the individual.

However, the nature of the aggregate supply curve is not that simple. There are two schools of thought popularly called as Classicals and Keynisians that promote the two differing slopes of aggregates supply curve that can be observed for an economy.

The

following

diagram

can

be

looked

upon

to

gain

a

brief

understanding of the concepts of Aggregate Supply curve preached by the two different schools. Institute of Lifelong Learning, University of Delhi

Aggregate Demand and Aggregate Supply

As clearly indicated in the diagram, the Keynesian range explains a flat or a horizontal aggregate supply curve. Keynes argued that economies are characterized by unutilized resources. Thus increased output of goods and services can be supplied at a given price. However, the classical range lies at the other extreme which preaches a vertical aggregates supply curve due to the classical belief of existence of the conditions of full employment in an economy. As per the classical school of thought, the economy is characterized by full employment of resources

and

thus

the

level

of

aggregate

supply

is

vertical

determining the potential of any economic system. However, between these two extremes lies an intermediate AS curve which is upward sloping and therefore indicates rising price level associated with increasing output. The Keynesian AS curve pertains to the short run supply behavior in an economic system. In short run, which has no specific definition, but is associated with low level of employment of the resources and idle Institute of Lifelong Learning, University of Delhi

Aggregate Demand and Aggregate Supply capacity of resources in the economy, any amount of increasing output can be supplied at a given price as the idle resources are brought into action without incurring any cost or rather incurring a very negligible cost of employing these resources. Classical AS curve corresponds to the long run where the potential of the economy is reached as all idle resources from the short run are now employed. Thus, the aggregate supply curve becomes vertical at a level of aggregate output determined by the availability of all the resources including manpower, machinery, raw materials etc.

3.1 Shifts in Aggregate Supply Curve

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Aggregate Demand and Aggregate Supply

In terms of the intermediate range, the positive and adverse supply shocks cause a rightward and a leftward shift of the Aggregate Supply curve. The positive supply shocks can be identified in terms of technological

improvements

that

enhance

the

production

and

consequently the supply of a given good or service, cheapening of the raw materials. The positive supply shocks leads to a rightward shift of the AS curve, (in diagram from AS1 to AS2 leading to a higher output being supplied at a given price level. Similarly, an adverse supply shock causing a leftward shift in the AS curve from AS1 to AS3 can be associated with a higher staff salaries bargained by trade unions, poor monsoon etc.

3.2 Interaction Between AS and AD

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Aggregate Demand and Aggregate Supply Keynesian economics is also known as demand side economics since Keynes highlighted the role Aggregate Demand could play for the smooth functioning of the economy.

DID YOU KNOW? The

Keynesian

demand

side

or

the

economics

emerged during the 1936 in his

book

theory

of

“The

general

Employment,

Interest and Money” during the Great Depression.

Source: mmtwiki.org Similarly, classical economics is also referred to as Supply side economics for the significant role that the classical school of thought Institute of Lifelong Learning, University of Delhi

Aggregate Demand and Aggregate Supply believes AS play in an economic system. However, to understand the functioning of the macro-economy, the role of neither of the two forces can be denied.

Source: article.wn.com Thus, it is crucial to understand the synthesis between these two macroeconomic tools and its implications of variables such as GDP and Aggregate Price level.

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Aggregate Demand and Aggregate Supply

The interaction of the short run and demand curve in the above figure coincides at Point A in the figure. Point A determines the output level Y and price level P for the given economy. However let us now look at point B, which is the point of lower price and output. Corresponding point B, the Aggregate Demand is much higher than AS at price Pe. Since, the demand is higher, the consumers are willing and able to bid higher price for the existing goods and services. This increasing the profit margin for the suppliers leads to a positive supply shock till the movement at the two curves leads to their interaction at the point of equilibrium i.e., point A.

Now, let us examine the AD or expansionary demand policy under various AS scenarios.

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Aggregate Demand and Aggregate Supply

To recall, the flat portion of the AS curve is the Keynesian Range. Under the Keynesian range which is characterized by unemployed resource, a rightward shift in the AD curve from AD1 to AD2 leads to a higher level of real output being produced by the economy at the original price level of P1. Similarly, let us now consider point B which lies at the vertical portion or Classical Range of the AS curve. The curve is vertical at fullemployment level of output as indicated by YFE. Under such scenario, if a positive shift in the aggregate demand occurs here from AD3

to

AD4,

then there only occurs a rise in price from P3 to P4 while the real output in the economy remains at the full employment level that is YFE. Let us now consider the rightward shift in the AD curve when there also occurs shifts in the vertical AS curve which can occur only when the overall resources in the economy increases and thereby expands Institute of Lifelong Learning, University of Delhi

Aggregate Demand and Aggregate Supply the output potential of the economy. It may occur if some potential resource is extracted and is now being used as an actual resource or some technical revolution occurs that leads to higher output being produced with the available resources.

As depicted in the figure, a rightward shift in the LRAS curve to LRAS2 together with a positive demand shift from AD1 to AD2 leads to the real national output of the economy expanding from Y1 to Y2 at the given level of prices.

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Aggregate Demand and Aggregate Supply

Exercises

Ques.1 Discuss the impact of contractionary fiscal policy (decline in government expenditure) on inflation and real output of an economy in short and long run?

Ques. 2 Calculate the equilibrium level of national income when o C = 160 + 0.24 Y, 𝐼 = Rs.200 crores, 𝐺 = Rs. 250 crores Ques.3 Discuss the features of short run and long run supply curve?

Ques.4

How

does

a

technical

revolution

that

enhances

agricultural

productivity affects long run supply curve of the economy?

Ques.5

Derive

the

Aggregate

Demand

Curve

using

the

Aggregate

Expenditure function and the 450 line? What causes AD curve to be downward sloping?

Ques.6 The quantity of real GDP available for sale in the market at various prices is depicted by the I. II. III.

Aggregate Demand Curve Aggregate Supply Curve Aggregate Expenditure Curve

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Aggregate Demand and Aggregate Supply Ques.7 In the long run, at full employment level of aggregate supply, the role of AD curve is to determine I.

real interest rate

II.

price level

III.

real output

Ques.8 An increase in autonomous taxes , causes AD curve to shift I.

Shift leftwards

II.

Shift rightwards

III.

No shift occurs

Ques.8 In long run, an increase in government expenditure raises I. II. III.

Real output Prices Real output and prices

Ques.9 In the Keynesian range of Aggregate Supply curve, an increase in aggregate demand, raises I. II. III.

Real output Price Real output and prices

Ques.10 A rise in labor costs employed in coal industry, causes the price of coal to, Institute of Lifelong Learning, University of Delhi

Aggregate Demand and Aggregate Supply I.

Increase

II.

Decrease

III.

Remain the same

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Aggregate Demand and Aggregate Supply References:

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