Aggregate Demand and Its Components

Introduction to the Keynesian Framework

The primary objective of macroeconomics is to develop theoretical models that explain how key aggregate variables like national income, price level, and employment are determined. This chapter focuses on the determination of National Income using the Keynesian theory, which was developed by John Maynard Keynes in the backdrop of the Great Depression. The model operates under a crucial short-run assumption: an economy with unused resources (e.g., unemployed labour and idle factories).

Under this assumption, two key conditions hold for our analysis:

1. Fixed Price Level: Since resources are unemployed, output can be increased by bringing them into use without causing a rise in production costs. Therefore, the overall price level is assumed to remain constant.
2. Perfectly Elastic Aggregate Supply: As a consequence of the fixed price level, producers are willing and able to supply whatever quantity of goods is demanded by the economy. Aggregate supply perfectly adjusts to aggregate demand.

This implies that in the Keynesian short-run model, the level of output and employment is determined solely by the level of Aggregate Demand.

Ex-ante vs. Ex-post Concepts

In macroeconomics, it is crucial to distinguish between what is planned and what actually happens. The terms ex-ante and ex-post are used for this purpose.

• Ex-ante Measures: These refer to the planned or intended values of variables at the beginning of a period. Examples include the amount a firm plans to invest or the amount a household intends to consume. The Keynesian theory of income determination is fundamentally based on these ex-ante variables because economic decisions are based on future expectations and plans.
• Ex-post Measures: These refer to the actual or realized values of variables at the end of a period, as recorded in national income accounts. For example, the amount a firm actually invested. By definition, in national income accounting, ex-post output is always equal to ex-post expenditure ($Y \equiv C + I$).

The ex-ante and ex-post values can differ due to unforeseen events. For instance, a firm might plan to increase its inventory by $\text{₹} \ 100$ (planned investment), but due to unexpectedly high sales, it has to sell from its existing stock, leading to an actual inventory increase of only $\text{₹} \ 70$ (actual investment). This difference of $\text{₹} \ 30$ represents an unplanned decrease in inventory. The equilibrium in the economy is achieved only when ex-ante values equal ex-post values, meaning there are no unplanned changes in inventories.

Components of Aggregate Demand (AD)

Aggregate Demand (AD) is the total planned spending on all final goods and services in an economy during a given period. In a simple two-sector model (consisting only of households and firms), AD has two components:

$AD = C + I$

1. Consumption (C)

Consumption expenditure by households is the largest component of AD. The most important determinant of consumption is the level of disposable income (Y). The relationship between consumption and income is described by the consumption function.

A simple linear consumption function is given by:

$C = \bar{C} + cY$

This function has two components:

• Autonomous Consumption ($\bar{C}$): This is the level of consumption expenditure that is independent of income ($\bar{C} > 0$). It represents the minimum consumption required for survival, which takes place even when income is zero. This spending is financed by drawing down past savings or by borrowing ("dissaving"). Graphically, it is the vertical intercept of the consumption function.
• Induced Consumption ($cY$): This is the portion of consumption that varies directly with the level of income. It is determined by the Marginal Propensity to Consume (MPC).

Propensities to Consume and Save

• Marginal Propensity to Consume (MPC or c): This is the ratio of the change in consumption to the change in income ($MPC = \Delta C / \Delta Y$). It represents the fraction of each additional rupee of income that households plan to spend on consumption. The value of MPC is always between 0 and 1 ($0 \le c \le 1$).
• Average Propensity to Consume (APC): This is the ratio of total consumption to total income ($APC = C/Y$). It represents the average proportion of income that is spent on consumption.
• Savings (S): Savings is that part of income which is not consumed ($S = Y - C$). By substituting the consumption function, we can derive the savings function:

  $S = Y - (\bar{C} + cY) = Y - \bar{C} - cY$

  $S = -\bar{C} + (1-c)Y$

  This shows that savings has a negative autonomous component ($-\bar{C}$) and an induced component that depends on income.

• Marginal Propensity to Save (MPS or s): This is the ratio of the change in savings to the change in income ($MPS = \Delta S / \Delta Y$). It represents the fraction of each additional rupee of income that is saved. From the savings function, the MPS is $(1-c)$.
• Average Propensity to Save (APS): This is the ratio of total savings to total income ($APS = S/Y$).

Since any additional income ($\Delta Y$) is either consumed ($\Delta C$) or saved ($\Delta S$), we have the fundamental identity:

$MPC + MPS = 1$

2. Investment (I)

Investment is defined as the addition to the stock of physical capital (such as machines, buildings, roads) and changes in the inventory of a producer. In reality, investment decisions by firms depend on factors like the market rate of interest and expected future profits. However, for simplicity in this introductory model, we assume that investment is autonomous. This means firms plan to invest a fixed amount every year, and this decision does not depend on the current level of national income.

The investment function is written as:

$I = \bar{I}$

where $\bar{I}$ is a positive constant representing the given or exogenous level of investment. Graphically, the autonomous investment function is a horizontal line parallel to the income (horizontal) axis.

Determination of Equilibrium Income in a Two-Sector Model

The equilibrium level of national income and output in the short run is determined at the point where the total planned spending in the economy (Aggregate Demand) is exactly equal to the total output being produced (Aggregate Supply or National Income). At this point, the economy is in a state of rest, with no tendency to change, because the plans of producers and spenders are consistent with each other.

The Equilibrium Condition

In a two-sector model, aggregate demand is the sum of planned consumption (C) and planned investment (I). Aggregate supply is the total output, represented by National Income (Y). The equilibrium condition is therefore:

Planned Aggregate Supply = Planned Aggregate Demand

$Y = AD$

This can also be expressed through an alternative but equivalent condition. Since income (Y) is either consumed (C) or saved (S), we have $Y = C + S$. The equilibrium condition $Y = C + I$ can be rewritten as:

$C + S = C + I$

This simplifies to:

$S = I$

Thus, equilibrium is also achieved when planned savings equal planned investment. This is known as the Savings-Investment approach.

Macroeconomic Equilibrium with Price Level Fixed

(A) Graphical Method: The Aggregate Demand-Supply Approach

The equilibrium level of income can be determined graphically by plotting the aggregate demand and aggregate supply functions on a diagram with income (Y) on the horizontal axis and planned expenditure (AD, AS) on the vertical axis.

1. Consumption Function - Graphical Representation

The consumption function $C = \bar{C} + cY$ is a linear equation. Graphically, it is an upward-sloping straight line.

• The line starts from a positive point on the vertical axis, equal to the value of autonomous consumption ($\bar{C}$). This is the "intercept".
• The line has a positive slope equal to the Marginal Propensity to Consume (c). The slope is less than 1, so the line is flatter than the 45-degree line.

2. Investment Function - Graphical Representation

We assume investment is autonomous, $I = \bar{I}$. This means planned investment is a constant amount regardless of the income level. Graphically, this is represented as a horizontal line parallel to the income axis at a height equal to $\bar{I}$.

3. Aggregate Demand (AD) Function - Graphical Representation

The Aggregate Demand function ($AD = C + I$) is obtained by vertically adding the consumption function and the investment function.

$AD = (\bar{C} + cY) + \bar{I} = (\bar{C} + \bar{I}) + cY$

• The AD curve is also an upward-sloping straight line.
• Its vertical intercept is the total autonomous expenditure, $\bar{A} = \bar{C} + \bar{I}$.
• It is parallel to the consumption function because they have the same slope, the MPC (c).

4. Aggregate Supply (AS) - The 45-degree Line

In the Keynesian model, aggregate supply is assumed to be perfectly elastic at the fixed price level. The total value of output produced (AS or Y) is equal to the total income generated. This relationship is represented by a 45-degree line from the origin. Every point on this line has the property that the vertical coordinate (Expenditure) is equal to the horizontal coordinate (Income). This line is therefore also called the line of reference.

5. Equilibrium

The equilibrium is determined at the intersection of the planned Aggregate Demand (AD) curve and the Aggregate Supply (AS) curve (the 45-degree line). At this point (E), planned expenditure equals income ($AD = Y$). The level of income corresponding to this point is the equilibrium level of income, $Y^*$.

(B) Algebraic Method

The equilibrium income level can be calculated by setting the aggregate supply equation ($AS = Y$) equal to the aggregate demand equation ($AD = C + I$).

Equilibrium Condition: $Y = AD$

Substituting the functions for C and I:

$Y = (\bar{C} + cY) + \bar{I}$

To solve for the equilibrium income ($Y^*$), we group the terms with Y on one side:

$Y - cY = \bar{C} + \bar{I}$

Factoring out Y:

$Y(1 - c) = \bar{C} + \bar{I}$

Let $\bar{A} = \bar{C} + \bar{I}$ be the total autonomous expenditure. Then the equilibrium income is:

$Y^* = \frac{\bar{A}}{1 - c} = \frac{\bar{C} + \bar{I}}{1 - MPC}$

Answer:

The Adjustment Mechanism: Disequilibrium Situations

The economy automatically adjusts to restore equilibrium through changes in inventories.

• If $Y > AD$ (Excess Supply): If the current output (Y) is greater than planned spending (AD), firms are producing more than people are willing to buy. This leads to an unplanned accumulation of inventories. To reduce these unwanted stocks, firms will cut back on production in the subsequent period. This causes Y to fall until it reaches the equilibrium level $Y^*$.
• If $Y < AD$ (Excess Demand): If planned spending (AD) is greater than the current output (Y), firms are selling more than they are producing. This leads to an unplanned depletion (or decumulation) of inventories. To replenish their stocks and meet the high demand, firms will increase production. This causes Y to rise until it reaches the equilibrium level $Y^*$.

Therefore, the equality between AD and Y is restored through the response of firms to unplanned changes in their inventories.

The Multiplier Mechanism

Effect of an Autonomous Change in Aggregate Demand on Income and Output

In the Keynesian model, the equilibrium level of income is determined by the level of aggregate demand. Therefore, any change in aggregate demand will lead to a change in equilibrium income. A change in AD can occur due to a change in consumption or investment. Since we have assumed autonomous investment ($\bar{I}$), it means it does not depend on income, but it can change due to other factors like the interest rate, availability of credit, or business expectations (often termed 'animal spirits').

When autonomous expenditure (like $\bar{I}$ or $\bar{C}$) increases, the AD curve shifts upwards in parallel. This creates an initial situation of excess demand at the old equilibrium level of income. To meet this demand, firms increase production, which in turn increases national income. A key finding of Keynesian analysis is that the final increase in income is a multiple of the initial increase in autonomous spending.

As shown in the figure, an initial increase in autonomous expenditure by $\Delta \bar{A}$ shifts the AD curve from AD1 to AD2. The economy moves from the initial equilibrium E1 to the new equilibrium E2. The resulting increase in income, $\Delta Y = Y_2^* - Y_1^*$, is significantly larger than the initial change in autonomous expenditure, $\Delta \bar{A}$. This amplified response is explained by the multiplier mechanism.

The Multiplier Mechanism Explained

The multiplier is the process through which an initial change in autonomous spending leads to a larger final change in national income. The mechanism works because "one person's expenditure is another person's income." The process unfolds in a series of successive rounds of spending and re-spending.

Let's trace the process with a numerical example. Assume there is an autonomous increase in investment ($\Delta \bar{I}$) of $\text{₹} \ 1,000$ crores, and the Marginal Propensity to Consume (MPC or $c$) is 0.8.

Explanation of the Rounds:

1. Round 1: The initial injection of $\text{₹} \ 1,000$ cr in investment directly increases AD. This expenditure becomes income for those who provided the investment goods and services. So, income rises by $\text{₹} \ 1,000$ cr.
2. Round 2: The recipients of this new income will spend 80% of it ($\text{₹} \ 800$ cr) on consumption and save 20% ($\text{₹} \ 200$ cr). This $\text{₹} \ 800$ cr of induced consumption is a further increase in AD and becomes income for the producers of these consumer goods.
3. Round 3: The recipients of the $\text{₹} \ 800$ cr will, in turn, spend 80% of it ($\text{₹} \ 640$ cr) and save 20% ($\text{₹} \ 160$ cr). This process continues.

The total increase in income is the sum of the income increases in all rounds:

$\Delta Y = 1000 + (0.8 \times 1000) + (0.8^2 \times 1000) + (0.8^3 \times 1000) + \dots$

This is an infinite geometric series. The process is convergent because the MPC is less than 1, meaning a portion of income "leaks out" as savings in each round, and the induced spending gets smaller each time.

The Investment Multiplier (or Autonomous Expenditure Multiplier)

The multiplier (denoted by $k$) is a numerical coefficient that measures the ratio of the total change in equilibrium income to the initial change in autonomous expenditure.

Derivation

We know the equilibrium equation is $Y = \frac{\bar{A}}{1 - c}$.

Let there be a change in autonomous expenditure, $\Delta \bar{A}$. This will cause a change in income, $\Delta Y$. The new level of income ($Y + \Delta Y$) will be:

$Y + \Delta Y = \frac{\bar{A} + \Delta \bar{A}}{1 - c} = \frac{\bar{A}}{1 - c} + \frac{\Delta \bar{A}}{1 - c}$

Since $Y = \frac{\bar{A}}{1 - c}$, we can substitute this into the equation:

$Y + \Delta Y = Y + \frac{\Delta \bar{A}}{1 - c}$

This simplifies to: $\Delta Y = \frac{\Delta \bar{A}}{1 - c}$

Rearranging this gives the formula for the multiplier, $k$:

Multiplier (k) = $\frac{\Delta Y}{\Delta \bar{A}} = \frac{1}{1 - c}$

Since $1 - MPC = MPS$ (or $1 - c = s$), the formula can also be written as:

Multiplier (k) = $\frac{1}{1 - MPC} = \frac{1}{MPS}$

Key Insights:

• Relationship with MPC: There is a direct relationship between the MPC and the size of the multiplier. A higher MPC means a larger multiplier, as less income leaks out into savings in each round.
• Relationship with MPS: There is an inverse relationship between the MPS and the size of the multiplier. A higher MPS means a smaller multiplier, as more income leaks out of the circular flow in each round.

In our numerical example, with MPC = 0.8, the multiplier is $k = 1 / (1 - 0.8) = 1 / 0.2 = 5$. The total increase in income is $\Delta Y = k \times \Delta \bar{I} = 5 \times \text{₹} \ 1,000 \text{ cr} = \text{₹} \ 5,000 \text{ cr}$.

The Paradox of Thrift

The Concept

The Paradox of Thrift is a fundamental and counterintuitive concept in Keynesian macroeconomics. It posits that while an increase in saving is considered a virtue for an individual household (as it leads to greater wealth), if the entire society attempts to save more simultaneously, the collective outcome can be detrimental to the economy. The paradox states that an increase in the economy's propensity to save will lead to a decrease in the equilibrium level of national income, and the total value of savings in the economy will either remain unchanged or could even fall.

In essence, the very act of trying to save more can lead to a recession, making the society poorer and ultimately failing to increase its total savings.

Explanation of the Paradox

The paradox arises because of the interconnectedness of spending and income in a macroeconomy, where one person's spending is another person's income. An individual decision to save more is simultaneously a decision to spend less.

Let's trace the mechanism step-by-step:

1. The Initial Decision: Suppose due to some external factor, like a forecast of economic hardship, all households decide to become more "thrifty." This means they increase their Marginal Propensity to Save (MPS). As a consequence, their Marginal Propensity to Consume (MPC) decreases (since MPC + MPS = 1).
2. Impact on Consumption and AD: A lower MPC means that at every level of income, households will now plan to consume less. This reduction in planned consumption leads to a downward shift and a flattening (reduced slope) of the Aggregate Demand (AD) curve.
3. Emergence of Excess Supply: At the original equilibrium level of income, planned aggregate demand is now lower than the total output being produced. This creates an excess supply of goods and services in the market.
4. Unplanned Inventory Accumulation: As consumption demand falls, firms find that their goods are not selling as expected. This leads to an unplanned and undesired buildup of inventories in their warehouses.
5. Production Cutbacks and Income Reduction: To clear these unwanted inventories and adjust to the lower demand, firms will cut back on production. A reduction in production means less employment of factors of production, leading to a fall in payments to households (wages, rent, profit), and thus a fall in the national income.
6. The Reverse Multiplier Effect: The initial drop in consumption spending triggers a negative multiplier process. The fall in national income causes a further (induced) fall in consumption, which leads to another round of production cuts and income reduction. This downward spiral continues until a new, lower equilibrium is reached.

The Outcome for Total Savings

The most paradoxical result relates to the total amount of savings. In the simple two-sector model, the equilibrium condition can be stated as Planned Savings = Planned Investment ($S = I$). Since we assume investment is autonomous ($\bar{I}$) and remains unchanged, for the economy to reach a new equilibrium, the total amount of planned savings must ultimately return to be equal to this fixed level of investment.

Although households are saving a larger fraction of their income (higher MPS), this is offset by the fact that they are now saving from a much smaller total income. The attempt to save more is foiled by the fall in income it causes.

Answer:

Excess and Deficient Demand

The Concept of Full Employment Level of Income

The equilibrium level of income, determined by the equality of AD and AS, is simply the level where the economy will settle if left to itself. However, this equilibrium does not necessarily correspond to the ideal state of the economy. It is crucial to compare this equilibrium level with the full employment level of income ($Y_f$).

Full employment level of income is defined as that level of income where all the factors of production in the economy (like labour and capital) are fully and efficiently employed in the production process. It represents the potential output of the economy, i.e., the maximum output that can be produced with the available resources and technology.

A key contribution of Keynes was to show that an economy can be in equilibrium at a level of income that is below the full employment level, a situation he termed "underemployment equilibrium."

Deficient Demand (Deflationary Gap)

Deficient demand is a situation where planned aggregate demand is less than the aggregate supply at the full employment level of output. This means that the total planned spending by households and firms is insufficient to purchase all the goods and services that the economy is capable of producing with its full resources.

• Cause: The level of aggregate demand is too low to sustain production at the full employment level. This could be due to low autonomous consumption or investment.
• Consequence: The economy reaches equilibrium at a level of income ($Y^*$) which is less than the full employment level ($Y_f$). The difference between the potential output and the actual output ($Y_f - Y^*$) is the output gap. This gap results in widespread involuntary unemployment, where people are willing to work at the prevailing wage rate but cannot find jobs due to a lack of overall demand.
• Deflationary Gap: The deflationary gap is the amount by which aggregate demand must be increased to reach the full employment equilibrium. Graphically, it is the vertical distance by which the actual aggregate demand curve is below the aggregate demand required to be in equilibrium at the full employment level ($Y_f$). This situation puts downward pressure on prices, leading to deflation in the long run.

Excess Demand (Inflationary Gap)

Excess demand is the opposite situation, where planned aggregate demand is greater than the aggregate supply at the full employment level of output. This means that households and firms are planning to buy more goods and services than the economy can possibly produce with its available resources.

• Cause: The aggregate demand is too high for the economy to satisfy. This could be due to a boom in investment, excessive government spending, or a consumption binge.
• Consequence: Since the economy is already at full employment, real output cannot be increased in the short run to meet this excess demand. The situation of "too much money chasing too few goods" creates intense competition among buyers. This competition bids up the prices of goods, services, and factors of production, leading to a sustained rise in the general price level, known as demand-pull inflation.
• Inflationary Gap: The inflationary gap is the amount by which aggregate demand exceeds the aggregate supply at the full employment level. Graphically, it is the vertical distance by which the actual aggregate demand curve is above the 45-degree line at the full employment level ($Y_f$). It measures the extent of excess demand and the pressure on the economy to generate inflation.

Answer:

Answer:

Answer:

Answer:

Answer:

Answer:

Multiple Choice Questions

Short Answer Type Questions

Long Answer Type Questions