AGGREGATE DEMAND AND AGGREGATE SUPPLY
Session-4
AGGREGATE DEMAND
Defined: o Amounts of Real Output o Buyers Collectively Desire o At Each Possible Price Level
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 consumers are willing to buy at a given price level Total demand for goods and services for a given price level
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 Aggregate Demand = Actual GDP It is the aggregate spending by the private sector, Govt. sector and net external sector on consumption and investment goods and services in the economy
Aggregate Demand thus made of
o Private Sector spending o Government sector spending o External sector spending
This spending happens on
o Consumption of Goods and Services o Investment in Goods and Services
DETERMINANTS OF AGGREGATE DEMAND
Change in Consumer Spending
o o o o Consumer Wealth Consumer Expectations Consumer Indebtedness Taxes
Change in Investment Spending
o Real Interest Rates o Expected Returns Expected Future Business Conditions Technology Degree of Excess Capacity Business Taxes
Government Spending Net Export Spending
o National Income Abroad o Exchange Rates
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
MARGINAL PROPENSITY TO CONSUME (MPC)
Change in consumption expenditure in response to change in disposable income DISPOSABLE INCOME: Divided into
o Consumption o Savings
AGGREGATE CONSUMPTION EXPENDITURE
Desire to have a smooth consumption throughout our lifetime Lifetime consumption path depends on lifetime income
o Income we receive from our work o Income we expect to receive from our wealth
Distinction between Permanent and Transitory Income
People try to maintain highest smooth consumption path they can get Derived from peoples expectations about permanent lifetime income both from work and wealth Current and past income from wealth and work play an important role in peoples expectations about lifetime income.
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, jewellery, etc Services all non-durable consisting of hair cut, laundry, transport, banking, insurance, health, education, legal and other services
DETERMINANTS OF CONSUMPTION
Income Wealth Relative income Interest rate Credit availability Consumers expectations Income/wealth distribution
FLUCTUATIONS IN CONSUMPTION DEMAND
Due to Changes in real disposable income Changes in personal tax rates Changes in Interest rates Erosion of wealth due to unexpected happenings.
INVESTMENT DEMAND
Investment means expenditure of funds on building new and fresh capital goods. Aggregate Investment Expenditure is for purchase of new assets which will help in production of future goods and services.
o Purchase new machinery o Expenditure on setting up of new plant
Investment for the economy means spending on physical capital, not financial capital(Equity and Debts)
CAPITAL STOCK
Rupee value of new plants, capital equipment, machinery 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 Agg. Demand Investments adds to the productive capacity, thereby enhancing the Agg. Supply 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 Fixed Residential Investments
DETERMINANTS OF AGGREGATE INVESTMENT EXPENDITURE
Output desired net investment is governed positively by the change in expected output Interest rate more investments so long as return from the investment exceeds cost Wage rate investment depends on the wage rate Tax laws Financing constraints Technology Business confidence/stock market behaviour Government/other factors
DETERMINANTSCONTD.
Expected permanent increase in returns.
o Based on current trends
Investment in capital stock happens if the investors feel that they can sell for more at a later date. Costs and other expected benefits Determinants of Costs
o Interest rates o Depreciation
Determinants of benefits of investment
o Expected growth in output
SAVINGS AND INVESTMENT
Saving is consumption forgone - If saving rises, 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. Thus aggregate savings and investment are equal. Savings form the backbone for investments viz., higher savings lead to higher investments and vice versa
An economy can have different forms of savings of which household financial savings generally constitute the largest share in aggregate domestic savings. Other forms of savings comprise physical savings by households, savings by the private corporate sector and the public sector and foreign savings Sometimes when savings exceed investment there would be deficiency of aggregate demand and general unemployment. Gap between S and I could be filled by government intervention either directly by increasing government expenditure or indirectly by actions influencing the supply of money
