Aggregate Demand and Related Concept

Aggregate Demand Aggregate Supply

Meaning: ‘Aggregate demand refers to volume Meaning: ‘Aggregate supply refers to volume of
of all goo all goods and services which is sale by all
ds and services which is purchased by all producer in fiscal year.
consumer in fiscal year.’
‘Aggregate supply refers to sale all goods and
‘Aggregate demand refers to buy all goods services by all individual during the period of
and services by all individual during the given time.’
period of time.’

Components of Aggregate Demand: Components of Aggregate Supply

1) Final Consumption Expenditure (C):
It refers to total expenditure incurred by 1) Consumption Expenditure (C):
households on consumer goods during the fiscal It refers to total expenditure incurred
year. by households on consumer goods
during the fiscal year.
2) Investment Expenditure (I):
It refers to total expenditure incurred by firms
on capital goods during fiscal year. 2) Saving (S): Saving refers to the
difference between income and
3) Government Expenditure (G): consumption.
It refers to total expenditure incurred by
government on both consumer and capital goods
during fiscal year.

4) Net Export (X-M):

It refers to difference between export and
import.

Components of Aggregate Demand in Two Sectors Model

1) Final Consumption Expenditure
2) Investment Expenditure

Formula of Aggregate Demand Formula of Aggregate Supply

AD = C + I AD = C + S
Schedule of AD Schedule of AS
Income Consumption Investment AD Income Consumption Saving AS

0 40 20 60 0 40 -40 0
100 120 20 140 100 120 -20 100
200 200 20 220 200 200 0 200
300 280 20 300 300 280 20 300
400 360 20 380 400 360 40 400
500 440 20 460 500 440 60 500

Diagram of AD Diagram of AS

Y AD Y AS (Y)

C + I = AD C C + I+ AD C

S
I

O Income X O Income X

With the help of schedule and diagram, we come With the help of schedule and diagram, we come
to know following points. to know following points.
Consumption: Consumption:
i) Consumption never become zero even on zero i) Consumption never become zero even on zero
income therefore consumption curve start from income therefore consumption curve start from
Y axis. Y axis.
ii) Consumption on 0 income is called ii) Consumption on 0 income is called
autonomous consumption. autonomous consumption.
iii) Consumption increases with increase in income iii) Consumption increases with increase in income
therefore consumption curve slope upward. therefore consumption curve slope upward.
Investment Expenditure:
i) Investment is always positive even on zero Saving:
income. Therefore investment curve start from i) Saving is negative on zero income therefore
Y axis. saving curve start from below X axis.
ii) Investment remains constant with increase in ii) Saving increases with increase in income
income therefore its curve is parallel to X-axis. therefore its curve slope upward.
Aggregate Demand: Aggregate Supply:
i) AD is always positive even on zero income i) AS is zero at zero income therefore its curve
therefore its curve start from Y-axis. start from origin.
ii) AD increases at increasing rate therefore its ii) AS increases at increasing income therefore
curve slope upward. its curve slope upward.
iii) AD is sum total of consumption and investment iii) AS is always equals to income therefore AS
therefore AD curve is always above and income is indicated by single line.
consumption and investment curve.

Consumption Function (Propensity to Consume)

“It refers to the functional relationship between consumption and national income.”
It is psychological concept because it is influenced by consumer’s preference, habits etc.
Schedule Diagram:
Income (Y) Consumption (C) y y
0 40
100 120 Consumption c
200 200
300 280
400 360
500 440
O Income X

Types of Propensity to Consume

There are two types of propensity to consume.

1) Average Propensity to Consume (APC)

2) Marginal Propensity to Consume (MPC)

Average Propensity to Consume (APC) Marginal Propensity to Consume (MPC)

Meaning: ‘APC refers to the ratio of Meaning: ‘MPC refers to the ratio of change in
consumption and income.’ consumption and change in income.’
Formula: APC = C/Y Formula: MPC = Change in C/Change in Y

Schedule of APC: Schedule of MPC

Income Consumption APC = C/Y Income Consumption ∆y ∆ C MPC

0 40 - 0 40 - - -
100 120 1.2 100 120 100 80 0.8
200 200 1 200 200 100 80 0.8
300 280 0.93 300 280 100 80 0.8
400 360 0.90 400 360 100 80 0.8
500 440 0.88 500 440 100 80 0.8

Important Points of APC Important Points of MPC

1) APC is more than 1: when 1) MPC is varies between 0 to 1
consumption is more than income. 2) MPC falls with increase in income:
2) APC is 1: When consumption is equals Because consumption increases at
to income. diminishing rate.
3) APC is less than 1: When consumption 3) MPC of poor is more than MPC of rich.
is less than income.
4) APC fall with increase in income:
Because consumption increases at
diminishing rate
5) APC never become zero: Because
consumption never become zero.

Saving Function (Propensity to Save)

“It refers to the functional relationship between saving and national income.”
Propensity to save shows different level of saving at different level of income.
Schedule: Diagram:
Income (Y) Saving (S) Y
0 -40
100 -20 S
200 0 Saving
300 20
400 40
500 60
O Income X

Types of Propensity to Save

There are two types of propensity to save.
1) Average propensity to save (APS)
2) Marginal propensity to save (MPS)
Average Propensity to Save (APS) Marginal Propensity to Save (MPS)
Meaning: ‘APS refers to ratio of saving and Meaning: ‘MPS refers to the ratio change in
national income.’ saving and change in national income.’
Formula: APS = S/Y Formula: MPS = ∆S/∆Y

Schedule of APS: Schedule of MPS:

Income Saving APS Income Saving ∆Y ∆S MPS

0 -40 - 0 -40 - - -
100 -20 -0.20 100 -20 100 20 0.2
200 0 0 200 0 100 20 0.2
300 20 0.07 300 20 100 20 0.2
400 40 0.10 400 40 100 20 0.2
500 60 0.12 500 60 100 20 0.2
Important Points of APS Important Points of MPS
1) APS is negative: When consumption is 1) MPS is varies between 0 to 1
more than income and saving is 2) MPS increase with increase in income:
negative. Because saving increases at increasing
2) APS is zero: When consumption is rate.
equals to income and saving is zero. 3) MPS of rich is more than MPS of poor.
3) APS is positive: When consumption is
less than income and income is
positive.
4) APS increases with increase in income:
Because saving increases at increasing
rate.
5) APS never become more than 1:
Because entire money is not saved.

Difference between APC and APS

 Average Propensity to Consume (APC) Average Propensity to Save (APS)

Meaning: ‘APC refers to the ratio of Meaning: ‘APS refers to ratio of saving and
consumption and income.’ national income.’

Formula: APC = C/Y Formula: APS = S/Y

Schedule of APC: Schedule of APS:

Income Consumption APC = C/Y Income Saving APS

0 40 - 0 -40 -
100 120 1.2 100 -20 -0.20
200 200 1 200 0 0
300 280 0.93 300 20 0.07
400 360 0.90 400 40 0.10
500 440 0.88 500 60 0.12

Important Points of APC Important Points of APS

1) APC is more than 1: when consumption 1) APS is negative: When consumption is
is more than income. more than income and saving is zero.

2) APC is 1: When consumption is equals 2) APS is zero: When consumption is

to income. equals to income and saving is zero.

3) APC is less than 1: When consumption 3) APS is positive: When consumption is

is less than income. less than income and income is
positive.
4) APC fall with increase in income:
Because consumption increases at 4) APS increases with increase in income:
diminishing rate Because saving increases at increasing
rate.
5) APC never become zero: Because
consumption never become zero. 5) APS never become more than 1:
Because entire money is not saved.

Difference between MPC and MPS

Marginal Propensity to Consume (MPC) Marginal Propensity to Sve (MPS)

Meaning: ‘MPC refers to the ratio of change in Meaning: ‘MPS refers to the ratio change in
consumption and change in income.’ saving and change in national income.’

Formula: MPC = Change in C/Change in Y Formula: MPS = ∆S/∆Y

Schedule of MPC Schedule of MPS:

 Income Consumption ∆ y ∆C MPC Income Saving ∆Y ∆S MPS
0 40 - - - 0 -40 - - -
100 120 100 80 0.8 100 -20 100 20 0.2
200 200 100 80 0.8 200 0 100 20 0.2
300 280 100 80 0.8 300 20 100 20 0.2
400 360 100 80 0.8 400 40 100 20 0.2
500 440 100 80 0.8 500 60 100 20 0.2
Important Points of MPC Important Points of MPS
4) MPC is varies between 0 to 1 4) MPS is varies between 0 to 1
5) MPC falls with increase in income: 5) MPS increase with increase in income:
Because consumption increases at Because saving increases at increasing
diminishing rate. rate.
6) MPC of poor is more than MPC of rich. 6) MPS of rich is more than MPS of poor.

Derivation of Saving from Consumption

1) When consumption is more than income, saving is negative.
2) When consumption is equals to income, saving is zero.
3) When consumption is less than income, saving is positive.

Linear Consumption Function

C = C + b (Y)
S=Y–C
Putting the value of C from (1) in (2), we get
S = Y – (c – b (Y))
S = -c + (1-b) Y.
Diagram
Y (Y)

Consumption E C

O Income X

Consumption

O R Income X