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LESSON – 7
AGGREGRATE DEMAND & RELATED CONCEPTS

Q.1 What do you understand by aggregate demand? State components of A.D.

Ans. Aggregate demand refers to the total amount of money which all sections of the economy are ready to spend on
purchase of final goods and services produced in an economy during an accounting period. Alternatively, aggregate
demand is the total demand for goods and services in an economy. There are four main components of A.D.
1) Private consumption demand: - This refers to total expenditure incurred by all households on purchase of
goods and services for their personal consumption. For instance households demand for goods, clothing,
housing, T.V. etc.
2) Private investment demand: - Private investment demand refers to the expenditure on creation of new capital
assets like machines, buildings and raw materials by the private entrepreneurs.
3) Govt. demand for goods and services:- Govt. demand for goods and services refers to the total amount of
expenditure incurred by the govt. on purchase of consumer and capital goods to cater (provide) the common
needs of the society.
4) Net export:- It is the difference between export of goods and services and import of goods and services during
a given period. Net export reflects the demand of foreign countries for our goods and services.
…………………………………..
Aggregate Demand in Two Sector Economy:
Since the determination of income and employment is to be studied in the context of two- sector model (households
and firms), the third and fourth components of aggregate demand are not discussed in detail. So, even though AD
has four components, we will assume that AD is a function of only consumption expenditure and investment
expenditure:
AD = C + I
AD depends upon the level of income in the economy. Generally, there exists a positive relationship between
income and the level of aggregate expenditure in the economy, i.e., as the level of income increases, AD also rises
and vice- versa. Let us understand this with the help of a table and a diagram.

Aggregate Demand Schedule

Income Consumption Investment AD

(Y) (C) (I) (C+I)
0 40 40 80
100 120 40 160
200 200 40 240
300 280 40 320
400 360 40 400
500 440 40 480
600 520 40 560

Important points about AD:

1. AD = C + I: As mentioned above it is assumed that AD is the function of only aggregate demand and
investment.
2. Positive Consumption, even when income is zero: There is always some minimum level of consumption,
even when the income is zero. It happens because people need certain basic goods and services to sustain
themselves, even if income is zero.
3. Slope of Consumption Curve: Slope of consumption curve is upward sloping because as income
increases consumption also increases.
4. Slope of autonomous investment curve: Investment curve is straight line parallel to X- axis as it is
assumed that it is independent of the level of income.
5. Starting point of AD curve: AD curve starts above the origin as consumption can never be zero at
zero level of output.
6. Slope of AD curve: AD curve has a positive slope which indicates that as income increases, AD curve or
aggregate expenditure also increases.

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Q.2 Explain the concept of aggregate supply?
Ans. Aggregate supply refers to money value of all final goods and services that all the producers are willing to supply in
an economy in a given time period. If we go deep, we will find aggregate supply is represented by national income.
How? The producers get the amount from sale of output. The amount depends upon what is paid to factors of
production in the form of rent, wages, interest and profit. Since, sum of factor incomes (rent, wages, interest &
profit) at national level is called national income, therefore, aggregate supply (AS) is reflected by national income.
A major portion of income is spent on consumption of goods and services and the balance is saved. Thus national
income or aggregate supply is sum of consumption expenditure (C) and savings (S). Put in the form of an equation:
AS = C + S
Diagrammatic representation of AS
The aggregate supply curve and national income curve coincide with each other. The nature of National Income
curve or AS curve can be made clear with the help of table and a curve;

Income Consumption Saving AS

(Y) (C) (S) (C+S)
0 40 -40 0
100 120 -20 100
200 200 0 200
300 280 20 300
400 360 40 400
500 440 60 500
600 520 80 600

Q.3 Explain the meaning of propensity to consume (consumption function).

Ans. The functional relationship between consumption and income is called consumption function (or propensity to
consume). Consumption function, thus, shows relationship between two variables, viz. income and consumptions.
Put into equation: C = f (Y).The relationship between income and consumption is shown in the table:

Income(Y) Consumption
0 40
100 120
200 200
300 280
400 360
500 440
600 520

Important observation from the table and the curve:

1. Starting point of consumption curve: Consumption curve (CC) starts from point C on the Y- axis. This
implies that there is autonomous consumption of OC even when the national income is zero.
2. Slope of consumption curve: CC has a positive slope, which indicates that as income increases,
consumption also rises. However proportionate rise in consumption is less than proportionate rise in
income as a part of income is saved.
3. Income is less than consumption: Initially income is less than consumption. This gap is covered by
utilizing previous savings.
4. Break even point: OM is the break- even point where income becomes equal to consumption. At this
point saving is zero.

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5. Income is more than consumption: At point to right of point E, income is more than consumption.
Excess of income leads to saving. The gap between the 450 line and CC line after point E represents
positive saving.

Q.4 What is Keynesian psychological law of consumption

OR
What is the relationship between propensity to consume and the level of income?
Ans. According to Keynes, as income increases, consumption expenditure also increases but by less than the increase in
income. In other word, when income increases consumption expenditure does not increase as fast as income. This is
called Keynesian psychological law of consumption. For instance, if income increases by 100 the consumption will
increase only 75 and the remaining 25 will be saved.

Q.5 Define average propensity to consume (APC).

Ans. The ratio of total consumption expenditure to total income is called APC. Symbolically :
C
APC 
Y
For instance if aggregate income of an economy is Rs. 5000 crores and aggregate consumption is
Rs. 4500, then
APC = 4500÷5000 = 0.9 or 90%
Important points about APC:
1. APC is more than one: As long as consumption is more than income the value of APC is more than one.
APC > 1.
2. APC = 1: At the break- even point, consumption is equal to national income.
3. APC is less than one: Beyond the break-even point, consumption is less than national income. As a result,
APC < 1.
4. APC falls with increase in income: APC falls continuously with increase in income as the proportion of
income spent on consumption keeps on decreases.
5. APC can never be zero: APC can be zero only when consumption becomes zero. However, consumption
is never zero at any level of income. Even at zero level of national income, there is autonomous
consumption.
Q.6 Define marginal propensity to consume (MPC).
Ans. The ratio of change in consumption (∆C) to change in income (∆Y) is called marginal propensity to consume. It is
the amount of extra consumption generated by extra unit of income. Symbolically :
MPC = ∆C
∆Y
For instance if income increases from Rs 5000 crores to Rs. 5500 crores and as a result, consumption expenditure
goes up from Rs. 4000 crores to Rs. 4300 crores then :
MPC = ∆C÷∆Y = 300÷500 = 3÷5 = 0.6 or 60%
Important Points about MPC:
1. Value of MPC varies between 0 to 1: We know that incremental income is either spent on consumption
or saved. If entire incremental income is spent on consumption then the value of MPC = 1. If entire
additional income is saved then the value of MPC = 0.
2. MPC of poor is more than 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.
On the other hand, rich people spend a smaller proportion of their income as they already enjoy a
high standard of living.
3. MPC falls with successive increase in income: It happens because as an economy becomes richer, it has
the tendency to consume smaller percentage of each increment to its income.
Q.7 Explain the following:
(a) Meaning of propensity to save
(b) Average propensity to save (APS)
(c) Marginal propensity to save (MPS)
Ans. a) Propensity to save : The functional relationship between saving and income is called saving function (or
propensity to save). In other words, saving (S) is a function (f) of income (Y). Algebraically:
S = f (Y)
Income (Y) Consumption Saving
(C) (Y-C)
0 40 -40
100 120 -20
200 200 0

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300 280 20
400 360 40
500 440 60
600 520 80

Important Observations from Saving Schedule and Saving Curve:

1. Starting Point of Saving Curve: Saving Curve (SS) starts from point S on the Y-axis, indicating that there is
negative saving when national income is zero.
2. Slope of Saving Curve: SS has a positive slope, which indicates the positive relationship between saving and
income.
3. Break even point (S=0): Saving Curve crosses the X-axis at point R, which is known as break-even point as at this
point, saving is zero (or consumption is equal to income.)
4. Positive Saving: After the break-even point, saving is positive.

b) Average propensity to save (APS): The ratio of total saving to total income is called APS. Symbolically
APS = S
Y
For instance, when national income is Rs. 200 crores, saving is Rs. 30 crores. In this case
APS = 30/200 = 0.15 or 15%

Income(Y) Saving(S) APS =S/Y

0 -40 _
100 -20 -0.20
200 0 0
300 20 0.067
400 40 0.10
Important Points about APS:
1. APS can never be zero or more than one: As saving can never be equal to or more than national income.
2. APS can be zero: APS can be zero at break- even point where income is equal to consumption.
3. APS can be negative or less than one: At income levels which are lower than the break-even point, APS can
be negative as there will be dissavings in the economy.
4. APS rises with increase in income: APS rises with increase in income because the proportion of income
saved keeps on increasing.

c) Marginal propensity to save (MPS): The ratio of change in saving (∆S) to change in income (∆Y) is called
MPS. It is a measure of additional saving as proportion of additional income. Symbolically :

MPS = ∆S
∆Y
For instance when national income goes up from 100 crores to 200 crores, saving also goes up from zero to  30
crores. In this case MPS = 30/100 = 0.3 or 30%
Important Observations about MPS:
1. MPS can never be Negative: As ∆C can never be more than
∆Y
2. MPS varies between 0 to 1: * If the entire additional income is saved, i.e. ∆C = 0, then MPS =1.
* If the entire additional income is consumed, i.e. ∆S = 0, then MPS = 0.

Q.8 With the help of consumption schedule or curve bring out the meaning of break-even point.
Ans. Break-even point refers to that point in the level of income at which consumption expenditure is just equal to
income. In other words, whole of income is spent on consumptions and as a result there is no saving. Below this
level of income, consumption is greater than income but above this level, income is greater than consumption. This
is illustrated with the help of following hypothetical schedule.
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Income (Y) Consumption Saving

(C) (Y-C)
0 40 -40
100 120 -20
200 200 0
300 280 20

In the above imaginary household’s schedule of consumption and saving, at annual income level of
Rs. 200 consumption is also Rs. 200 and in consequence there is no saving. This is called break-even point
Q.9 Explain the meaning of Ex-ante saving and Ex-post saving.
Ans. Ex-ante saving (planned saving):- It refers to the amount of savings which households (or savers) plan to save at
different levels of income in the economy. The amount of ex-ante saving is determined by the propensity to save
(saving function)
Ex-post saving (real-saving):- It refers to the actual saving or realized saving in an economy during an accounting
period. What the savers actually save or what is left after deducting consumption expenditure from income, is called
ex-post or realized saving.

Q.10 Explain the meaning of Ex-ante investment and Ex-post investment.

Ans. Ex-ante investment:- It refers to the amount of investment which firms plan to invest at different levels of income
in the economy. The amount of ex-ante or planned investment is determined by the relation between investment
demand and rate of interest.
Ex-post investment:- It refers to the actual or realized investment in an economy during a period of account.

Q.11 What happens to level of income when ex-ante (planned) savings are less than ex-ante investment
Ans. When planned (ex-ante) saving is less than planned investment, then AD (or consumption expenditure) is more than
AS. Production will have to be increased to meet the excess demand. Consequently national income will increase
leading to rise in saving until saving becomes equal to investment. It is here that equilibrium level of income is
established because what the savers intend to save becomes equal to what the investors intend to invest.

Q.12 What happens to level of income when ex-ante (planned) savings are more than planned investment.
Ans. When planned saving is more than planned investment, AD (or consumption expenditure) is less than AS (or
consumption is less than production). There will be stock piling and producers will produce less. National income
will fall and as a result saving will start falling until it becomes equal to investment. It is at this point that
equilibrium level of income is determined.

Q.13 Differentiate between induced investment and autonomous investment.

Ans. Induced investment :- Induced investment refers to the investment which is made
with the motive of earning profit. It is done in private sector. Induced investment
directly depends upon profit expectations. It is income
elastic. If national income goes up, induced investment also goes up.

Autonomous investment:- It refers to the investment which is made

irrespectively of level of income. It is generally done in govt. sector
for public welfare. It is income inelastic. It is not affected by change
in income level. The volume of autonomous investment is the same
at all levels of income.

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Q.14 Draw a straight line consumption curve for an economy. From it derive the saving curve, explain the method
of derivation. Show a point on the consumption curve at which average propensity to consume is equal to
one.
Ans. The derivation of saving curve can be explained with the help of a diagram. As seen in the diagram, CC is the
consumption curve and 450 line OY represents the income curve.
 At zero level of income, autonomous consumption ( C ) is equal to OC. It means, saving at zero level
of income will be OS. As a result, saving curve will start from point S on the negative Y-axis.
 Consumption curve CC intersects income curve OY at point E. This is the break - even point. At point
E, consumption = income, i.e. APC =1 and saving is zero. It means, saving curve will intersect X-axis
at point R. By joining the points S and R and extending it further, we get the saving curve SS.

Q.15 Investment demand depends on MEI and interest rate. Explain.(Marginal Efficiency of Investment)
Ans When MEI is greater than the interest rate, private investors increases the investment to make profits. This
investment will continue to rise till MEI and interest rate would not become equal.
With increase in volume of investment, MEI declines because due to more production and rate of interest goes
up. Thus, there is inverse relationship between volume of investment and MEI. Hence, we can say that volume of
investment will be more if rate of interest is less and vice-versa. It can be illustrated with the help of following
schedule and diagram:

Investment MEI Interest

(Rs. Crores) (%) (%)
100 25 5
200 20 10
300 15 15
400 10 20
500 5 25

Q.16 Write a short notes on the following:

1) concept of involuntary unemployment
2) concept of full employment.

Ans. Concept of involuntary unemployment:- Involuntary unemployment means a situation in which all able persons
who are willing to work at the prevailing wage rate cannot get work. Thus their unemployment is involuntary. This
type of unemployment is due to deficiency of AD.

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Concept of full employment:- Full employment refers to a situation in which every able bodied person who is
wiling to work at the prevailing rate of wages is employed. Generally, the term full employment means that there is
no unemployment, i.e. everyone gets work. It means, demand for labor is equal to its supply. But in economics full
employment does not mean zero unemployment or cent percent employment.

Under full employment there are two types of unemployment:

i) Frictional Unemployment: It refers to temporary unemployment, which exists during the period wherein
workers leave one job and join some other. Introduction of new machines, nationalization in production process or
breakdown of plant may also lead to frictional unemployment.
ii) Structural Unemployment: It refers to the unemployment, in which people remain unemployed due to
mismatch between unemployed persons and the demand for specific type of workers. It is associated with structural
changes in the economy. For example due to computerization, workers who do not possess enough knowledge of
computers will unemployed until they do some computer course or training.

Q.17 What is Voluntary Unemployment?

Ans. Voluntary Unemployment refers to a situation when a person is unemployed because he is not willing to work at the
existing wage rate. In an economy, it is always possible to find some people who are unwilling to do any productive
work though they may be fit physically and mentally. Voluntary unemployment is not counted while estimating the
size of unemployment.

Important Formulas At A Glance

Consumption function: C = c  bY
AD = C + I
AS = C + S
APC = C/Y Saving function: S =  C  (1  b)Y
C Y 1 1
MPC  K (Multiplier) =  
Y I 1  MPC MPS
APS = S/Y Excess demand: AD > AS at full employment
C Deficient demand: AD < AS at full employment
MPC 
Y Economy attains equilibrium when: AS = AD or S = I
APC + APS = 1
MPC + MPS = 1

Q.1 Calculate APC and APS from the following schedule:

Income(Y): 100 200 300
Consumption (C) 80 120 180

Q.2 If APC of an economy is 0.8, what should be saving at an income level of Rs. 2,000 crores?
Ans. Saving= Rs.400 crores.
Q.3 i) The disposable income is Rs. 1200 crores and consumption expenditure is Rs. 800 crores. Calculate the APC.
ii) If saving is Rs. 500, out of an income is Rs. 5000, how much is the APC.
iii) If disposable income is Rs. 1000 and consumption expenditure is Rs. 750, find out average propensity to save.
iv) If income is Rs. 500 and saving are Rs. 100, calculate APC.
v) When income rises from Rs. 1000 to Rs. 1100, saving rise by 30. Find out MPS and MPC.
Ans. (i) 0.67 (ii) 0.10 (iii) 0.25 (iv) 0.80 (v) 0.70
Q.4 Calculate MPC from the following data:
Income (Y) : 0 100 200 300 400
Consumption: 60 110 150 180 200

Q.5 The level of income, in an economy, increases from Rs. 20,000 crores to Rs. 70,000 crores, and as a result the level
of consumption increases from Rs. 15,000 crores to Rs. 45,000 crores. Calculate the MPC.
Ans.= 0.6
Q.6 Calculate the value of MPS from the given table:
Income : 100 200 300 400 500
Saving : 15 40 70 110 160

Ans. = 0.25, 0.30, 0.40, 0.50

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Q.7 Complete the following table:

Income Saving MPC APC

0 - 12 - -
20 - 6 - -
40 0 - -
60 6 - -
Solution:
Income Saving Con. (C) MPC APC
0 - 12 12 - -
20 - 6 26 0.70 - 0.30
40 0 40 0.70 0
60 6 54 0.70 0.10

Q.8 Using the equation of consumption function: : C = c  bY , calculate consumption expenditure at the income level
of Rs. 500 crores, if autonomous consumption is Rs. 40 crores and 40% of additional income is saved.
Ans. = Rs. 340 crores.
Q.9 With the help of saving function: S = -20 + 0.3Y, Calculate consumption expenditure at income level of Rs. 1,000
crores. Ans. = Rs. 720 crores.
Q.10 On the basis of consumption function: C = 120 + 0.40Y, answer the following questions:
i) Drive the saving function.
ii) Determine the saving at the income level of Rs. 500 crores.
iii) At what level of income, saving becomes zero?
Ans. (i) S = -120 + 0.60Y; (ii) S = Rs. 180 crores; (iii) Y= Rs. 200 crores
Q.11 If MPC is one- third of MPS and consumption at zero level of national income is Rs. 40 crores, derive the
consumption and saving function.
Ans. C = 40 + 0.25Y; S = -40 + 0.75Y
Q.12 The consumption function for an economy is C = 20 + 0.8Y. Determine the level of income when average
propensity to consume will be one. Ans. Rs. 100 crores.
Q.13 The break- even level of income for an economy is given to be Rs. 10,000 crores. If the economy saves 20% of
additional income, then calculate the value of autonomous consumption. Ans. Rs. 2000 crores.
Q.14 Given below is the consumption function of an economy:
C = 100 + 0.5Y.
With the help of numerical example, show that in this economy, as income increases, APC will decrease.

HOT, VALUE BASED & MULTIDISLIPNIARY QUESTIONS

Q.1 On the basis of the diagram, answer the following questions:

(i) What is the value of autonomous consumption?
(ii) What is the break- even point or at what point saving is zero?
(iii) How much is APC corresponding to point E?
(iv) If MPC= 0.6, determine the consumption and saving function.
Ans. (i) Rs.40 crores; (ii) Break- even level of income is Rs.100 crores; (iii) APC = 1; (iv) C= 40+ 0.6Y
S= -40+0.4Y

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Q.2 The consumption function of an economy is given as: C = 60 +0.6Y. Draw a diagram showing consumption
expenditure corresponding to income levels of 0, 100, 200, 300 and 400.

Q.3 Explain the relationship between MPC and MPS.

Ans. The sum total of MPC and MPS is equal to unity.
It can be proved as follows:
We know that income (Y) is either consumed (C) or saved (S) i.e.
Y=C+S
So, Y  C  S
Y C S
By dividing both sides by Y , we get   or
Y Y Y
1 = MPC + MPS
Q.4 Explain the relationship between APC and APS.
Ans. The sum of APC and APS is equal to one.
It can be proved as follows:
We know that income (Y) is either consumed (c) or saved (s) i.e.
Y=C+S
Y C S
By dividing both sides by Y, we get   or
Y Y Y
1 = APC + APS
Q.5 Exports fall 15% to 1718.07 crores in first 6 months of 2015. (Business Standard)
How will this affect aggregate demand in the economy?
Ans. Fall in export would be reflected as a fall in aggregate demand because, export is a component of aggregate
demand.

Q.6 Do you think increase in MPS should be beneficial to the growth of GDP in India?
Ans. Increase in MPS implies that people start saving more when their income rises. This is good for the GDP growth,
provided people put their savings in the banks and the banks are able to convert savings into investments. However,
in countries like India where banking habits of the people are yet not grown, savings may remain as idle cash
balances with the people. Implying that additional income of the people is not converted into additional demand.
This may cause deficiency of AD which is a serious set- back for GDP growth.

Q.7 Why should rising MPS be a cause of worry when it is a sign of rising GDP in the economy?
Ans. Rising MPS implies falling MPC, as MPS + MPC = 1. It means lesser and lesser proportion of the additional
income goes to consumption expenditure. Implying a gradual shrinkage of AD in relation to Y. In such a situation,
the economy might slip into a state of recession or economic slowdown.

Q.8 In India propensity to consume is fairly high, why is it that the manufacturing sector in India shows a low
rate of growth because of low demand?
Ans. High propensity to consume in India is primarily because of low income of the people. When income is low, the
bulk of it is used as expenditure on food and allied items. Having spent the bulk of their income on food and related
items, the people have limited capacity to buy manufactured goods. Thus, demand for manufactured goods remain
low, which is why, manufacturing sector shows a low rate of growth.

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