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  • 1. Aggregate Demand Aggregate supply eNotesMBA The Best References for MBA
  • 2. Aggregate DemandMeaningAggregate demand is the total demand made by allmembers of the society for all goods and services. Inmacroeconomic analysis such aggregate demand isa function of the general level of prices. Here, the priceof any individual good or the demand for it from anindividual member is not under consideration.It is the demand for all goods and its dependence onthe level of all prices that is being analyzed.
  • 3. Such a general level of prices is in the form of a priceindex which is usually Consumer’s Price Index (CPI)/Wholesale Price Index (WPI)This demand on the other hand represents demand forreal national income which can be denoted as Yr.Aggregate Demand (AD) is then a function of the pricelevel (P) and the relation between the two can beexpressed in the form of a schedule
  • 4. By scheduled pairs of prices and AD quantities we meanthat at arbitrarily given prices, expected quantitiesdemanded are related. On the basis of a demandschedule we can also represent it graphically. AD Schedule Price level AD quantities or Yr 6 10 5 12 4 18 3 30 2 44 1 60
  • 5. In the AD Schedule we notice an inverserelationship between level of prices andthe quantities or real income. As the price AD Schedulelevel falls (through 6 to 1) Aggregate Price level AD quantities or YrDemand goes on increasing (from 10 6 10through 60). In the figure, the same 5 12information has been presented 4 18graphically (in the form of the AD curve). 3 30In the figure price has been measured 2 44along the vertical and AD quantity along 1 60the horizontal axis. The inverse relationbetween the two is apparent since the ADcurve slopes downwards.
  • 6. AD SchedulePrice level AD quantities or Yr 6 10 5 12 4 18 3 30 2 44 1 60
  • 7. Inverse RelationshipIn case of the individual demand curve the price - quantity relation is inverse andhence the demand curve slopes downwards.This is because of both substitution effect which is negative and income effect which ispositive. In such cases we concentrate only on the changes in the price of asingle commodity, assuming prices of all the substitute goods to be constant.Therefore the good (say X) for which price rises, becomes relatively dearer, and part ofits demand is shifted to other substitutes which are relatively cheaper.Therefore the demand for good X falls. On the other hand, with rise in the price, theconsumer’s real income falls since the purchasing power of his money incomedecreases (he will have to shell out more money to buy the same amount of good X atits higher price).Hence his demand for good X decreases. Therefore both price and income effectscause demand to fall with a rise in the price of a good.
  • 8. In case of changes in aggregate demand and generalprice level such a simple relation does not hold good.In this case since prices of all the goods are risingsimultaneously there cannot be any substitutioneffect.Moreover, with rising price level money income oflabor and other factor owners who provide theirservices is likely to go up. Therefore, their capacity tospend is likely to increase and demand for goods mayactually rise, instead of falling, or may at least remainconstant even with a rise in price level.
  • 9. For this reason, the inverse relationship (downward slopingcurve) of the aggregate demand curve cannot be explainedwith the same reasoning as that of the individual demandcurve.Yet the price level and aggregate demand continue to hold anegative or inverse relation because of the presence of thethree distinct effects.
  • 10. Three EffectsThere are three different effects operating on theaggregate demand as a result of rising price level, orunder inflationary conditions.These are1. Wealth Effect,2. Rate of interest Effect and3. Trade Effect.
  • 11. AD Schedule Wealth EffectPrice ADlevel quantities or Yr Professor A.C. Pigou had first stated and 6 10 analyzed wealth effect under inflationary 5 12 4 18 conditions of the price level changes. With a 3 30 rise in the price level, value of the given 2 44 1 60 money income of consumers (assuming supply of money to be constant) decreases.
  • 12. With a fall in the purchasing power of their incomeconsumers become poorer and have to reduce theirconsumption.By way of an example a person with fixed money income ofRs. 100 can purchase 25 units of a commodity, price of thecommodity being Rs. 4. But s/he can purchase only 20 unitsof the commodity when price rises to Rs. 5.Thus the real income or wealth of aconsumer diminishes from 25 to 20 even when his moneyincome is constant.
  • 13. Such a wealth effect results in the consumer reducing hisdemand with a rising price level. Contrary would be the caseunder the conditions of deflation and falling prices.In that case his wealth effect will be positive and enable himto purchase larger quantities of all goods and services.Hence, the presence of the wealth effect continues tomaintain an inverse relation between price level changesand aggregate demand
  • 14. Rate of interest EffectRate of interest is also a price like all other prices ofgoods and services. It is the price paid for the use ofmoney or for the use of loanable funds.Rate of interest also shows a tendency to move upwardunder inflationary conditions or rising prices. With risingprice level and with a constant supply of money, there isan increased demand for liquidity or money and creditresources
  • 15. This is because the rising price level reduces purchasingpower of money. Hence a greater quantity of money is neededto carry out a given volume of transactions.Both households and producers create an increased demandfor money under conditions of rising price level. Consequently,with constant supply, growing demand for money tends to raiseits price in the form of rate of interest. With higher rates ofinterest, borrowing becomes dearer and the tendency to saverather than consume is induced.
  • 16. Consequently demand for goods and services both fromconsumers and investors starts declining. Therefore a risinglevel of prices results in a fall in the aggregate demand due toa rise in the rate of interest.
  • 17. Rising level of prices finally causes fall in the aggregate demand via foreigntrade effect. Under the conditions of inflation domestic prices of goods arehigher than international price levels.This makes import of goods attractive since import prices are lower andgoods are cheaper than domestic products.Again because of an inflationary rise in the prices of export goods, foreigndemand for exported goods declines.Both these processes together reduce demand for domestically producedgoods and services.
  • 18. Shifts in DemandAs in the case of the individual demand curve, aggregate demandcurve shows a tendency to shift leftward or rightward. The demandcurve shifts in this manner when aggregate demand tends torise without any change in the domestic price level. In other wordsthis occurs when aggregate demand alters for causes otherthan changes in the price level.There are a variety of causes contributing to shifts in aggregatedemand. When the public authority increases its expenditure, morepurchasing power is put in the hands of people who create anincreasing demand.
  • 19. If the rates of taxes are reduced then again people’s capacity tospend increases and aggregate demand will rise. Internationaldemand and supply conditions may also contribute to shifts inthe aggregate demand curve.Rising price level in countries abroad may make exports of acountry relatively cheaper and cause an increased demand forexports. On the contrary under such conditions imported goodsbecome relatively dearer, the demand for which declines andthis results in a rise in demand for indigenous products.When all these factors are moving in the opposite direction,they will result in a fall in the aggregate demand and rightwardshift in the AD curve.
  • 20. In the figure DD is the original demand curve.On this demand curve at a given price levelP1 aggregate demand is of the size q1.But when the demand curve shifts rightward orupward, as D1D1 then at the same price levelP1 demand increases from q1 to q2. This meansthat there has been an increase in demand atthe same price.If we consider the higher demand curve D1D1 tobe the initial demand curve, then the demandcurve DD denotes leftward or downward shift.This time it means that at the same price therehas been a decrease in demand.
  • 21. Aggregate SupplyAggregate supply is the total quantity supplied by theproducers and sellers. In the scheduled form it is presentedthrough a range of expected quantities supplied at arbitrarilychosen prices. Aggregate Supply Schedule Price Quantity supplied 1 5 2 15 3 30 4 48 5 58 6 60
  • 22. Direct RelationshipAggregate supply shows a direct relationship with the changes inthe price level. As price level rises (from 1 through 6) the quantitysupplied goes on increasing (from 5 through 60).The direct relationship between price and aggregate supply isdue to the same reason as in the case of individual supply curve.In both the cases the cost of production goes on increasing withevery addition to the goods produced.Therefore more and more supply can be made only when theprice level is rising in order to cover rising cost of production.
  • 23. The quantity supplied has been measured alonghorizontal axis and price level has been shown on thevertical axis.Because of the direct relation between the two, thesupply curve O-AS is continuously rising upwards.However, there is an important difference in thebehavior between individual and aggregate supplycurves.
  • 24. An individual supply curve is moderatelysteep throughout. But in case of aggregatesupply curve, two distinct phases arenoticeable. Initially the AS curve is flatter andrises upwards only gradually.In the figure ON is such an initial phase. Butlater on the AS curve becomes steeper andfinally becomes a vertical straight line. In thefigure, N-AS is such steeper phase.
  • 25. The Two PhasesInitially, at the low levels of output produced and supplied, a verysmall proportion of available resources is utilized.So long as labor, plants and equipment, land etc. are underutilizedor unemployed, marginal cost of employing them is relatively low.Therefore more and more output can be produced and suppliedwith reasonably small rises in the price level
  • 26. But as resource utilization tends to afuller level, the marginal cost ofemploying resources starts risingsharply. Ultimately, when allavailable resources are exhausted,the condition of no further supply ofreal goods and services is reached(that is the full employment level).If the price level beyond this pointcontinues to move upward it can nomore induce additional productionand supply. Rising price level willthen be purely inflationary withoutadding any more to the output level.
  • 27. Aggregate supply curve may shift upwards(leftward) or downwards (rightward).In figure O-AS1 is the original supply curveand AS2 - AS2 is the new upwards orleftwards shifted Aggregate Supply curve.On the new supply curve at a given priceP1aggregate supply has decreased from q1 toq2.If we were to start initially from O-AS1curvethen O-AS would have been a rightward or adownward shifted supply curve showinggreater quantity supplied at a given pricelevel.
  • 28. Such shifts in the supply curve are caused by avariety of dynamic changes taking place inthe economy.Technological improvements, skill development oflabor, innovation, foreign trade prospects aresome of examples of it. These factors may causeeither favorable or unfavorable effects on thesupply conditions.Their unfavorable nature causes an upward shiftand favorable effects lead to a downward shift. Inthe long run, a downward shift in the aggregatesupply conditions is normally experienced whenan economy has been making progress anddevelopment.
  • 29. Short and Long Run SupplyAggregate supply curve has two phases.Initially on the flatter portion more andmore output can be produced with a smallrise in the price level.This is possible so long as some resourcesare unemployed or underemployed. Butonce the economy reaches a point closeto full employment of resources, thesupply curve becomes very steep andvertical.
  • 30. These two phases can be associatedwith short and long run transitions inthe aggregate supply conditions aswell.The flatter initial phase is a short-term phenomenon whereas steepervertical portion is experienced in thelong run.The distinction is based on the factthat progressive fuller utilization ofavailable resources is a time-consuming activity.
  • 31. Relatively flatter short run supply curves while figure 15 shows long run supply curves. Corresponding to the two earlier phases there are separate supply
  • 32. EquilibriumGiven the supply and demand curves in their aggregate form,an equilibrium level can be established at the point oftheir intersection.AD and SAS are such short run curves. The two haveintersected at point E which is the equilibrium; the price thatis commonly offered and received is P and quantityexchanged is Y (P and Y bar).This is only an initial equilibrium and it can alter with a shift ineither the demand or supply curves.
  • 33. Such a shift upwards in the aggregate demand curve has been shown. This causes equilibrium position to shift as well from E to E1. In the new equilibrium position price level rises from P to P1 and real output quantity exchanged increases from Y toY1. Such an increase in the real output becomes possible because between E and E1we were still operating along the short run supply phase, where some resources were underutilized.But once the point E1 is reached the supply curve becomes steepand vertical. Here the full employment level is reached and nomore resources are available for further additions to be made tothe real output. Therefore E1Y1 is a vertical full employment longrun supply curve (LAS). Points such as E are partial equilibriumunder employable points.
  • 34. we have an interesting case where aggregate demand shifts and increases beyond full employment level. In this case E1 is the original point of equilibrium with AD1 and SAS1 having intersected at this point. However this happens to be the full employment condition and LAS passes through this point which is Y1E1. If aggregate demand further shifts upwards as shown by AD2 then a new point of equilibrium is attained at E2 where AD2 and SAS1 have intersected. The new price level is then P2 and output quantity
  • 35. However, since all available resources were fully employedand exhausted at Y output level, this increase is purely amonetary phenomenon caused by rising price level.Therefore movement from Y1 to Y2 is only an increasein money value of the real output.This becomes possible because contracted agents ofproduction have secured a hike in their wages, rent andinterests. As a result of increase in input prices andconsequent rise in the cost of production, the supply curveshifts upwards as SAS2. Yet another point of intersectionbetween AD2 and SAS2 becomes possible at a newequilibrium level E.In this equilibrium position we revert to the old fullemployment level of output Y1though the price level is nowhigher than before as P2. Thus in the long run after alladjustments have taken place the economy settles down atthe full employment level and only price level rises upwardsdue to inflationary pressure.
  • 36. Besides, there is another contributory factor which causes lapse of time between the twophases. Several resource agents or factors of production are employed on the basis ofcontracted remuneration. Rate of wages, rent of land and building premises, interest on the loanfunds are all examples of contract payments.These contracts last for six months, a year or for a longer period. With an initial rise in the pricelevel contracted factor payments do not rise and quick expansion in the output becomespossible at fairly steady costs. This explains the short run, flatter portion of the supply curve.But after the lapse of time when the contractual period is over the factor agents demand higherremuneration to compensate for the inflationary price rise.This suddenly causes cost of production to rise sharply. The long run supply curve thereforetends to get steeper and gradually attain a vertical shape. But that both the causes namely fullerutilization of resources and renewal of contracts at higher factor prices together causesteepness and rigidity in the long run supply conditions