Aggregate Demand and Related Concepts Class 12 Notes

Aggregate demand is the aggregate expenditure that different sectors of the economy are willing to incur during a given period.

Note: There exist 4 sectors in the economy –

a) Household
b) Firms
c) Government Sector
d) Rest of the World

Components of Aggregate Demand

Private Consumption Expenditure

It refers to the total expenditure incurred by households on the purchase of goods and services during an accounting year.

Investment Expenditure

It refers to the total expenditure incurred by all the private firms on capital goods such as machinery, equipment, buildings, etc. as well as change in inventory.

Government Expenditure

It refers to the total expenditure incurred by the government on consumer goods & capital goods to satisfy the common needs of the economy. It includes –

• Consumption Expenditure: It is incurred to meet public needs like law & order, education, health, transport, defense, etc.
• Investment Expenditure: It involves the construction of highways, roads, power plants, etc.

Net Exports (X-M)

The difference between exports and imports is termed net exports.

Exports indicate demand for goods produced within the domestic territory of a country by the rest of the world.

Imports refer to the demands of the residents of a country for the goods that have been produced abroad.

AD = C+I+G+(X-M)

Note: Even though AD has four components, we will assume that AD is a function of only consumption expenditure & investment expenditure. i.e., AD=C+I

Curve of Aggregate Demand

Explanation of the Curve

• AD=C+I: AD is assumed to be a function of consumption, demand, and investment demand.
• Positive consumption even when income level is zero: There is always some minimum level of consumption even when the income is zero.
  It happens because people need certain basic goods & services to sustain themselves even if their income is zero. Such consumption at a zero level of income is known as autonomous consumption.
• The Slope of Consumption Curve: The consumption curve slopes upward because consumption increases with an increase in income.
• The slope of the Autonomous Investment Curve: The investment expenditure (I) is a straight line parallel to the x-axis because it is assumed to be independent of the level of income.
• Starting point of AD curve: The AD curve starts from point A at 0 level of national income.
• The slope of the AD Curve: The AD curve has a slope that indicates that as income increases AD or aggregate expenditure also increases.

Aggregate Supply

AS refers to the monetary value of final goods and services that all the producers are willing to supply in an economy in a given time period.
AS can also be termed as National Income.

Components of Aggregate Supply

The major portion of national income is spent on the consumption of goods & services and the balance is saved. It means income is either consumed or saved therefore, Y=AD=C+S.

Diagrammatic Representation of Aggregate Supply

• The aggregate supply & national income curve coincide with each other.
• Income is represented on the x-axis & consumption & savings are measured on the y-axis.
• A 45-degree line has been drawn from the origin, it represents aggregate supply.

Consumption Function

Consumption function refers to the functional relationship between consumption & national income.

C=f(Y)
C= Consumption
Y= Income
f= Functional Relationship

It represents the willingness of households to purchase goods & services at a given level of income during a given time period.

Types of Propensities of Consume

There are 2 types of propensity to consume:
1) Average Propensity to Consume (APC)
2) Marginal Propensity to Consume (MPC)

Average Propensity to Consume

APC refers to the ratio of consumption expenditure to the corresponding level of income.

APC = Consumption/Income

Important Points about APC

• APC is more than 1 as long as consumption is more than income APC is greater than 1 (before the break-even point).
• APC=1 at break-even points, consumption= National Income.
• APC is less than 1 when consumption is less than national income after the break-even point.
• APC falls with an increase in income because the proportion of income spent on consumption keeps on decreasing.
• APC can never be zero as it can only be zero when consumption is zero but consumption is never zero at any level of income.

Marginal Propensity to Consume

MPC refers to the rate of change in consumption expenditure to change in total income.

Important Points about MPC

• The value of MPC varies between 0 and 1: As incremental income is either spent on consumption or saved for the future.
  If the entire additional income is consumed then delta S=0 & MPC is equal to 1.
  If the entire additional income is saved then delta C=0 then MPC is equal to 0.
• MPC of the poor is more than that of the rich: It happens because poor people spend a greater percentage of their increased income on consumption as most of their basic needs remain unsatisfied where whereas rich people spend a small proportion as they already enjoy a high standard of living.
• MPC falls with successive increases in income: It happens because as an economy becomes richer it has the tendency to consume a smaller percentage of each increase in its income.

Propensity to Save

Saving function refers to the function relationship between savings and national income.
S=f(Y)
S= Savings
Y= National Income
f= Functional Relationship

The propensity to save shows different levels of saving at different levels of income in an economy.

• National income is measured on the x-axis & saving is measured on the y-axis.
• The starting point of the Saving curve indicates that there is negative saving when national income is zero.
• The Saving Curve has a positive slope that indicates the relationship between savings & income.
• The saving curve crosses the x-axis at point E which is known as the break-even point as at this point saving is zero.
• After the break-even point, saving is positive.

Types of Propensities to Save

There are two types of propensities to save:
1) APS(Average Propensity to Save)
2) MPS(Marginal Propensity to Save)

Average Propensity to Save

It refers to the ratio of savings to the corresponding level of income.

APS=S/Y

• APS can never be 1 or more than 1: As saving can never be equal to or more than national income.
• APS can be 0: APS is equal to zero at the break-even point where income=consumption.
• APS can be negative or less than 1: At income levels that are lower than the break-even point, APS can be negative. As there will be dissavings in the economy.
• APS rises with an increase in income: APS rises with an increase in income because the proportion of income saved keeps on increasing.

Marginal Propensity to Save

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

MPS=delta Savings/delta Income

MPC varies between 0 to 1 as if the entire additional income is saved then delta C = 0, it implies MPS=1.
If the entire additional income is consumed then delta S=0, it implies MPS=0.

Income Determination and Multiplier Notes Class 12

Relationship between APC & APS

The sum of APC & APS is equal to 1.

We know that, Y=C+S
Dividing both sides by Y
Y/Y = C/Y+S/Y
1=APC+APS

Relationship between MPC & MPS

The sum of MPC & MPS is equal to 1.

We know that delta Y = delta C + delta S
Dividing both sides by delta Y
delta Y/delta Y = delta C/delta Y+ delta S/delta Y
1 = MPC+MPS

Difference between Autonomous and Induced Investment

Ex-Ante Saving & Ex-Ante Investment

Ex-ante saving refers to the amount of savings that the households plan to save at different levels of income in the economy.

Ex-ante investment refers to the investment that the firms plan to invest at different levels of income in the economy.

Note: When planned saving is equal to the planned investment, it is said to be an equilibrium.

Ex-Post Saving & Ex-Post Investment

Ex-post savings refers to the actual savings in an economy during the year. Ex-post savings is the total of planned savings & unplanned savings.

Ex-post investment refers to the actual investment in an economy during a year. It is the total of planned investment and unplanned investment.

Full Employment

Full employment refers to a situation in which all those people who are willing & able to work at the existing wage rate get work without any undue difficulty.

Full employment does stand for 0 unemployment or 100 percent employment. Under full employment, there can be 2 types of unemployment:
1) Frictional Unemployment
2) Structural Unemployment

Frictional Unemployment

It refers to the temporary unemployment that exists during the period wherein workers leave one job & join some other job.

It arises due to factors like lack of market information about the availability of jobs or lack of perfect mobility on the part of workers.

Structural Unemployment

It refers to unemployment in which people remain unemployed due to a mismatch. Unemployed person & the demand for specific types of workers. It is associated with structural changes in the economy.

Note: The presence of structural & frictional unemployment is referred to as the normal wage rate of unemployment.

Involuntary Unemployment

It refers to unemployment in which all those people who are willing and able to work at the existing wage rate do not get work.

Voluntary Unemployment

It refers to a situation when a person is unemployed because he/she is not willing to work at the existing wage rate.