CBSE Class 12 Economics - Aggregate Demand and Related Concepts


AGGREGATE DEMAND

Aggregate demand is total demand for final goods and services in the economy, that all sectors of the economy are planning to buy at a given level of income during a period of time.

Aggregate demand, in fact, represents the total planned expenditure on goods and services in an economy, during a period of time.

Components of Aggregate Demand:

  1. Private( household) consumption expenditure (C): it refers to total expenditure incurred by households 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 the government on consumers good and capital goods to satisfy the common needs of the economy. It  means government incurs both consumption expenditure ( education, health, transport, etc) as well as investment expenditure( roads, infrastructure,etc.)
  4. Net Exports( X-M): the difference between exports and imports is termed as NET export.

  NET EXPORTS= EXPORTS - IMPORTS

AGGREGATE DEMAND= C+I+G+(X-M)

AGGREGATE DEMAND IN A TWO SECTOR ECONOMY:

As we have to study income and employment in the context of two - sector economy which does not include.

Government and foreign sector therefore, we will ignore 3rd and 4th component of AD. So, we will assume that it is a function of only consumption expenditure and investment expenditure that is AD=C+I.

IMPORTANT POINTS ABOUT AD:

  1. AD=C+I, as stated before, AD is assumed to be a function of consumption and investment only.
  2. Positive consumption, even when income level is zero: there is always some consumption even when income is zero. the consumption at zero level of income is called autonomous consumption.
  3. Slope of consumption curve: consumption curve is upward sloping as consumption increases with increase in income. However,  the proportionate increase in income is more than the increase in consumption as after reaching a particular level, people start saving a part of the income.
  4. The Slope of autonomous investment curve:  Investment curve is the straight line parallel to x-axis as it is assumed to be independent of the level of income.
  5. Starting point of a d curve: AD starts from point R as at zero level of income AD= C+I.
  6. Slope of AD curve: AD curve is upward sloping which represents that aggregate demand increases with rise in income.

AGGREGATE SUPPLY

Aggregate Supply refers to the value of total final output available in an economy during a given period. In fact, it represents the national income of a country during a period of time that is AS= Y where Y is national income.

Components of Aggregate Supply or National Income:

Y= CONSUMPTION(C) + SAVINGS (S)

Y= AS=C+S

CONSUMPTION FUNCTION ( propensity to consume)

Consumption Function refers to that part of income which is spent on the purchase of goods and services at a given level of income. Consumption function refers to  the functional relationship between consumption and national income.

C= f (Y),where C= consumption, f= functional relationship, Y= national income

Consumption Function represents the willingness of households to purchase goods and services at the given level of income during a given time period.

It is a psychological concept as it is influenced by subjective factors like consumers preference, habits, etc.


IMPORTANT OBSERVATIONS FROM SCHEDULE AND DIAGRAM

  1. Starting point of consumption curve: consumption curve starts from point P on y axis this implies that there is autonomous consumption even when national income is zero.
  2. Slope of consumption curve: consumption curve has a positive slope, which shows that consumption Rises, with rise in income but the proportionate increase in income is more than that of consumption as after a certain level a part of income is saved.
  3. Income is less than consumption: when income is less than consumption, the amount spent on consumption comes from Savings and this is known as dissaving.
  4. Break even point: when income is equal to consumption, it is known as break even point which is represented by point E on graph.
  5. Income is more than consumption: when income is more than consumption a part of income is saved. excess of income leads to savings.

TYPES OF PROPENSITY TO CONSUME

  1. Average Propensity to Consume(APC)
  2. Marginal Propensity to Consume(MPC)

AVERAGE PROPENSITY TO CONSUME

Average propensity to consume is a ratio of total consumption to total income.

SYMBOLLICALY, APC= consumption(C)

                                        Income(Y)

In simple terms, it means that out of total income how much is consumed.

IMPORTANT POINTS ABOUT APC

  1. APC is more than 1: when consumption is more than national income, APC is greater than one that is before break even point.
  2. ApC is equal to 1: when consumption is equal to National Income, APC is equal to one that is at break even point
  3. APC less than 1: when consumption is less than income, APC is less than one that is after break even point
  4. APC Falls with rise in income: APC Falls continuously with rise in income as portion of income spent on consumption keeps on decreasing.
  5. APC can never be zero: APC can never be zero as consumption can never be zero even at zero level of income.     

MARGINAL PROPENSITY TO CONSUME(MPC)

Marginal propensity to consume is the ratio of change in consumption to change in income.

symbollicaly,

                        MPC= Change in consumptionΔC

                                       Change in incomeΔY

IMPORTANT POINTS ABOUT MPC

  1. Value of MPC lies between 0 and 1: as an increase in income is either consumed or saved and if it is fully consumed, MPC would be one has changed in saving is equal to zero and if it is fully saved, mpc would be zero as change and consumption is equal to zero and if it is a combination of both that is a part is safe and remaining is consumed, the value of MPC lies between 0 and 1.
  2. MPC of poor is more than that of rich: since most of the needs of poor people are unsatisfied, they spend a large part of increased income for consumption. Viraj when the income of rich people increases, this is a large part of it as they already enjoy a high standard of living.
  3. MPC Falls with a successive increase in income: It happens because as an economy becomes richer, it has the tendency to consume a smaller percentage of each increment to its income.

SAVING FUNCTION ( propensity to save)

Saving function refers to the functional relationship between saving and national income.

SYMBOLLICALY,

S=f(Y)

Where, S= saving, Y= national income , f= functional relationship.

IMPORTANT POINTS ABOUT SAVINGS CURVE

  1. The starting point of savings curve: saving car starts from point P on y-axis indicating that there are negative savings( equal to the amount of autonomous consumption) when national income is zero.
  2. The slope of savings curve: saving curve has a positive slope which indicates a positive relationship between saving and income.
  3. Break-even point: saving curve cross x-axis at point e, this is break-even point at which savings are zero.
  4. Positive saving: After the break even point, saving becomes positive as now a part of the increase in income is saved.

TYPES OF PROPENSITY TO SAVE

  1. Average propensity to save( APS)
  2. Marginal propensity to save( MPS)

AVERAGE PROPENSITY TO SAVE(APS)

Average propensity to save is the ratio of saving to total income.

symbolically APS=S/Y

basically, it tells how many parts of income is saved.

IMPORTANT POINTS ABOUT APS:

  1. APS can never be one or more than one: are saving can never be equal to or more than income, APS can never be more than or equal to 1.
  2. APS can be zero: be possible that total income earned be consumed fully and nothing is saved, at this point APS would be zero it is also known as the break-even point.
  3. APS can be negative or less than 1: when income is lower than the break-even point, APS can be negative as consumption is made out of past savings, which is known dissavings.
  4. APS Rises with rising in income: APS Rises with rising in income as a proportion of income safe keeps increasing.

MARGINAL PROPENSITY TO SAVE

It refers to the ratio of change in savings to change in income.

symbolically, MPS=ΔS/ΔY

In simple terms, it means that how much part of increase income is saved.

MPS varies between 0 and 1. if entire additional income is saved, then change in consumption=0 and MPS= 1.

If entire additional income is consumed, then change in saving=0 and MPS=0.

RELATIONSHIP BETWEEN APS & APC

As income can either be consumed or safe, the sum of APS and APC is always one.

it can be proved as under:

Y=C+S

Dividing both sides by Y, we get,

Y/Y=C/Y+S/Y

1=APC+APS

RELATIONSHIP BETWEEN MPS & MPC

Since and increase in income can either be consumed or safe, the sum of MPC and MPS is always one it can be proved as under:

If entire additional income is consumed, then change in saving=0 and MPS=0.

ΔY= ΔC+ ΔS

Dividing both sides by Δy, we get.

ΔY/ΔY= ΔC/ΔY + ΔS/ΔY

1=MPC+MPS

EQUATION OF CONSUMPTION CURVE

Consumption curve can be put into two parts:

  1. When income is zero, there is some consumption which is known as autonomous consumption.
  2. When income increases, consumption also increases but the rate of increase in income is more than that of increasing consumption and this date depends upon MPC or (b). the consumption pictures influenced by income is known as induced consumption which can be estimated by multiplying MPC by income. i.e b(Y)

Therefore consumption can be represented as,

C= C̅+b(Y)

Where C̅=Autonomous consumption

             C= consumption,     b= MPC

            Y= Income

For example- C̅= 50 crores , MPC= b=0.60,  Y= 200crores. Find consumption.

C=50+0.6(200)

C=50+120

C=170 crore

EQUATION OF SAVING FUNCTION

With the help of linear consumption function situations, we can derive the equation of the linear saving function.

We know, Y=S+C

                 S=Y-C………………(1)

And         C=C̅+b(Y)………….(2)

Putting the value of C in equation 1 we get.

S=Y-(C̅+b(Y))

S=Y-C̅-b(Y)

S= -C̅+Y-b(Y)

S=-C̅+Y(1-b)

Where, S=savings

            -C̅=amount of dissavings at 0 levels of income.

                Y= total income

             1-b= 1-MPC=MPS

FOR EXAMPLE- if C̅= 50 crore, MPS=(1-b)= 0.40, Y= 200 crore, fing saving.

S= -40+200(0.40)

S=-40+80

S=40 Crores.


DERIVATION OF SAVING CURVE FROM CONSUMPTION CURVE

Let us understand how we derive the saving curve from the consumption curve:

  1. At 0 level of income, autonomous consumption is OC which means that savings will be OS and hence saving curve will start from the point as on the negative y-axis.
  2. Consumption curve intersects income curve at. Which means it is break-even point where consumption is equal to income, and savings are zero. therefore at this particular point saving curve will intersect the x-axis at point r. by joining. S and R and extending it further, we get the saving curve SS.

If you want to derive consumption curve from saving curve, we can do that also in the same manner.

INVESTMENT FUNCTION

Investment refers to the expenditure incurred on the creation of New Capital Asset. for example, expenditure incurred on the purchase of machinery, building, equipment, etc.

It can be of two types:

  1. Induced investment
  2. Autonomous investment

INDUCED INVESTMENT

Induced investment is that investment which is directly influenced by the level of income that is it increases with income and it falls with a fall in income. these are made for profit Motive.

AUTONOMOUS INVESTMENT

Autonomous investment refers to investment which is not influenced by the level of income. these are not made for-profit motive.

  • These types of investments are generally made by the government on infrastructure activities.
  • The level of autonomous investment depends upon social, economic and political conditions of any country hence its take it changes when there is a change in technology on the discovery of new resources or growth of population, etc.

DETERMINANTS OF INVESTMENT

Investment in a new project depends upon two factors:

  1. Marginal efficiency of investment
  2. Rate of interest.

MARGINAL EFFICIENCY OF INVESTMENT

Marginal efficiency of investment refers to the expected rate of return from additional investment.

It is determined by two factors:

  1. Supply price: it happens to the cost of producing a new asset of that kind. it is the price at which the new capital can be supplied or replaced. for example, if a machine of rupees 1100000 is replaced in place of an old machine, then Rupees 1 lakh is supplied price
  2. Protective yield: it refers to net return expected from the Capital Asset over its lifetime. for example, if the expected yield from a machine is rupees 8000 and running expenses are rupees 500 then protective Shield could be rupees 8000 - 500 is equal to Rs 7500.

Here, in the above example MEI will be calculated as follows:

MEI= Protective yield/ supply price X 100

MEI= 7500/100000 =7.5%

RATE OF INTEREST

It happens to the cost of borrowing money for financing Investments. there exist an inverse relationship between ROI and volume of investment as if ROI would be hiring people with borrow less money to make an investment and vice versa.

COMAPARISON OF MEI & ROI

Profitability of an investment can be worked out by comparing MEI with ROI. IF MEI >ROI, investment is profitable as at this point, return from investment is more as compared to cost and if MEI<ROI, investment is not profitable as at this point return from investment is less as compared to cost.

EX-ANTE & EX-POST SAVING AND INVESTMENT

EX-ante means planned or expected value of the variable, whereas EX-post means an actual or realized value of the variable.

Both are generally used in the context of saving and investment. There are two aspects of Savings and Investments:

  1. Ex Ante saving and Ex Ante investments
  2. Ex-post saving and Ex post investments

EX-ANTE SAVINGS

Refers to the amount which households are planning to save at different level of income in the economy.

EX-ANTE INVESTMENTS

It refers to the amount of investment which firms plan to invest at a different level of income in the economy.

It must be noted that an economy would be at equilibrium when ex-ante savings are equal to ex-ante investment.

EX-POST SAVINGS

Exposed saving refers to actually organized saving in an economy during the year.

EX-POST INVESTMENTS

It refers to actual or realized investment in an economy during a year.

FULL EMPLOYMENT

Full employment refers to a situation in which all those people who are willing and able to work at the existing wage rate, get work without any due difficulty. ordinarily, the term full employment refers to the situation in which no one is employed.

However that can be some type of unemployment, they can be two types of unemployment:

  1. Frictional unemployment: sometimes people leave one job in search for some other job and remain vacant between this period, which is termed as frictional unemployment.
  2. Structural unemployment: effects on unemployment, where people remain unemployed because they do not match with a specific type of job. for example, due to the introduction of new technology, the old staff become unemployed as now they do not possess enough exercise to do a particular job.

FULL EMPLOYMENT

It refers to an unemployment people who are willing and able to work at the existing wage rate, do not get work.

It must be noted that only involuntary unemployment is considered while estimating the total unemployment in an economy.