Aggregate Demand and related concepts.pptx

Aggregate Demand and related concept

1. Meaning and components of Aggregate Demand Aggregate Supply Consumption Function (propensity to Consume) Types of Propensities to consume Saving Function (Propensity to Save) Type of Propensities to Save Investment Function Determinants of Investment Ex-ante and Ex-post Saving and Investment Full employment and Involuntary Unemployment CONTENTS

2. Aggregate demand (AD) refers to the total value of final goods and services which all the sectors of an economy are planning to buy at a given level of income during a period of one accounting year. Components of Aggregate Demand: MEANING AND COMPONENTS OF AGGREGATE DEMAND AD = C + I + G + (X – M)

3. Private (Household) Consumption Expenditure (C):  It refers to the total expenditure incurred by households on purchase of goods and services during an accounting year.  Investment Expenditure (I):  It refers to the total expenditure incurred by all private firms on capital goods. It includes addition to the stock of physical capital assets such as machinery, equipment, buildings, etc. and change in inventory. Government Expenditure (G):  It refers to the total expenditure incurred by government on consumer goods and capital goods to satisfy the common needs of the economy. It means, government incurs consumption expenditure as well as investment expenditure. Net Exports (X – M):  Exports indicate demand for goods produced within the domestic territory of a country by the rest of the world. Imports refer to demands of the residents of a country for the goods that have been produced abroad. The difference between exports and imports is termed as net exports.

4. Aggregate Demand in a Two-Sector Model (AD = C + I) 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, i.e. AD = C + I.

5. Diagrammatic Representation of AD 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 rises, AD also rises and vice-versa.

6. Important Points about AD: AD = C + I: AD is assumed to be a function of only 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. In Table 7.1, consumption of 40 crores (when Y = 0), is termed as autonomous consumption (c). Slope of Consumption Curve: Consumption curve slopes upwards because consumption increases with increasing income. The proportionate increase in consumption is, however, less than income. Slope of Autonomous Investment Curve: Investment expenditure (I) is a straight line parallel to the X-axis as it is independent of the level of income.

7. Aggregate supply (AS) refers to money value of final goods and services that all producers are willing to supply in an economy in a given time period. Aggregate Supply = National Income Components of Aggregate Supply (AS) or National Income (Y): The major portion of national income is spent on consumption, and the balance is saved. It means, Income (Y) is either consumed or saved: Y = AS = C + S AGGREGATE SUPPLY

8. Diagrammatic Representation of AS At every point on the 45° line, Y = C + S.

9. Consumption refers to functional relationship between consumption and national income. C = f (Y) Where, C = Consumption, Y = National Income, f = Functional relationship CONSUMPTION FUNCTION (PROPENSITY TO CONSUME)

10. Important Observations Starting Point of Consumption Curve: Consumption curve (CC)starts from point C on the Y-axis. Slope of Consumption Curve: CC has a positive slope, which indicates that as income increases , consumption also rises. Income is less than Consumption: When income is less than consumption, the gap is covered by dissavings (i.e. by utilizing previous savings. COE represents dissavings . Break-even point (C =Y): At OM level of income(as represented by point E), consumption becomes equal to income and saving is zero. The point E is known as the ‘ Break-even point’. Income is more than Consumption: Excess of income leads to savings. The gap between the line is significant as it indicates whether consumption spending is equal to, greater than, or less than the level of income.  

11. TYPES OF PROPENSITIES TO CONSUME Average Propensity to Consume (APC) Marginal Propensity to Consume (MPC) Average Propensity to Consume (APC): Average propensity to consume refers to the ratio of consumption expenditure to the corresponding level of income. If consumption expenditure is 70 crores at national income of ₹ 100 crores, then: i.e. 70% of the income is spent on consumption.  

12. Important Points about APC APC is more than 1: As long as consumption is more than national income, i.e. before the break-even point, APC > 1. APC = 1: At the Break-even point, consumption is equal to national income. So, APC = 1 at the income level of ₹200 crores. APC is less than 1: Beyond the break-even point, consumption is less than national income. As a result, APC < 1. APC falls with increase in income: APC falls continuously with increase in income because the proportion of income spent on consumption keeps on decreasing. 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 (c).

13. Let us understand APC with the help of following schedule and diagram:

14. Marginal Propensity to Consume (MPC) Marginal propensity to consume refers to the ratio of change in consumption expenditure to change in total income. MPC explains what proportion of change in income is spent on consumption.  

15. Let us understand MPC with the help of following schedule and diagram:

16. Important Points about MPC Value of MPC varies between 0 and 1: We know, incremental income is either spent on consumption or saved for future use. If the entire additional income is consumed, i.e. ΔS = 0, then MPC = 1. However, if entire additional income is saved, i.e. ΔC = 0, then MPC = 0 In normal situations, value of MPC varies between 0 and 1. MPC of poor is more than that of 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 as they already enjoy a high standard of living. Similarly, MPC of developing countries like India, Bangladesh, etc., is more than MPC of developed countries like America or England. 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.

17. Comparison between APC and MPC Basis APC MPC Meaning It is the ratio of consumption expenditure (C) to the corresponding level of income (Y) at a point of time. It is the ratio of change in consumption expenditure (ΔC) to change in income (ΔY) over a period of time. Value more than one APC can be more than one as long as consumption is more than national income, i.e. till the break-even point. MPC cannot be more than one as change in consumption cannot be more than change in income. Response to When income increases, APC falls but at a rate less than that of MPC. When income increases, MPC also falls but at a rate more than that of APC. change in income Formula APC = C/Y MPC = Δ C/ Δ Y

18. Like consumption, saving is also a function of income, i.e., saving also depends upon the level of income. Saving is the excess of income over consumption expenditure. Saving function refers to the functional relationship between saving and national income. S = f (Y) Where, S = Saving; Y = National Income; f = Functional relationship 'Saving Function' or 'Propensity to Save' shows the saving of households at a given level of income during a given time period. Alternately, Propensity to save shows the different levels of saving at different levels of income in an economy. SAVING FUNCTION (PROPENSITY TO SAVE)

19. The relationship between saving and income is illustrated below

20. Important Observations from Saving Schedule and Saving Curve: Starting Point of Saving Curve: Saving curve (SS) starts from point S on the Y-axis, indicating that there is negative saving (equal to amount of autonomous consumption) when national income is zero. Note: The saving curve will have a negative intercept on Y-axis of the same magnitude as the consumption curve has positive intercept on the Y-axis. It happens because if consumption is positive at zero level of income, then there would be dissavings of the same magnitude. Slope of Saving Curve: SS has a positive slope, which indicates the positive relationship between saving and income. 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). According to Table 7.6, break-even point occurs corresponding to income of ₹200 crores. Positive Saving: After the break-even point, saving is positive.

21. Propensities to save are of two types: Average Propensity to Save (APS) Marginal Propensity to Save (MPS) Average Propensity to Save (APS): Average propensity to save refers to the ratio of saving to the corresponding level of income. If saving is 30 crores at national income of ₹100 crores, then: i.e. 30% of the income is saved.   TYPE OF PROPENSITIES TO SAVE

22. The estimation of APS is illustrated with the help of Table 7.7 and Fig. 7.7.

23. Important Points about APS 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: In Table 7.7, APS = 0 as saving are zero at the income level of ₹ 200 crores. This point is known as Break-even point. APS can be negative or less than 1: At income levels which are lower than the break-even point, APS can be negative as there will be dissavings in the economy (shown by the shaded area in Fig. 7.7). APS rises with increase in income: APS rises with increase in income because the proportion of income saved keeps on increasing.

24. Marginal Propensity to Save (MPS): Marginal propensity to save refers to the ratio of change in saving to change in total income. If saving increases from ₹ 30 crores to ₹ 90 crores with an increase in income from 100 crores to 200 crores, then: i.e. 60% of the incremental income is saved for future.  

25. Important Points about MPS MPS varies between 0 and 1: If the entire additional income is saved, i.e. ΔC = 0 then MPS = 1. However, if entire additional income is consumed, i.e. ΔS = 0, then MPS = 0. In normal situations, value of MPS varies between 0 and 1. Slope of Saving Curve: It is measured as the ratio between ΔS (additional saving) and ΔY (additional income) and this is known as MPS. In Table 7.8, MPS is constant at 0.20. Due to constant MPS, saving curve (Fig. 7.8) is a straight line, i.e. Saving Function is linear.

26. Comparison between APS and MPS Basis APS MPS Meaning Ratio of saving (S) to corresponding level of income (Y) at a point of time. Ratio of change in saving (ΔS) to change in total income (ΔY) over a period of time. Value less than zero APS can be less than zero when there are dissavings, i.e. till consumption is more than national income. MPS can never be less than zero as change in saving can never be negative, i.e. change in consumption can never be more than change in income. Formula APS = S/Y MPS = Δ S/ Δ Y

27. Relationship between APC and APS The sum of APC and APS is equal to one. It can be proved as under: We know:  Dividing both sides by Y, we get Therefore, APC + APS = 1, because income is either used for consumption or for saving. Relationship between MPC and MPS The sum of MPC and MPS is also equal to one. It can be proved as under: We know: Dividing both sides by  , we get: Therefore, MPC + MPS = 1, because total increment in income is either used for consumption or for saving.  

28. Equation of Consumption Function The Consumption Function can be put into two parts: ( i ) Even when income (Y) is zero, there is some minimum consumption, known as autonomous consumption (c) which is always positive. (ii) When income increases, consumption also increases. But, the rate of increase in consumption is less than rate of increase in income. The MPC (or b) shows how consumption expenditure (C) changes with changes in income. This portion of consumption is termed as Induced Consumption and can be estimated by multiplying MPC by Income, i.e. b(Y). So, Consumption Function can be represented as: C = c + b(Y) {Where: C = Consumption; c = Autonomous Consumption; b = MPC; Y = Income}

29. Equation of Saving Function: With the help of the equation of linear consumption function, we can derive the equation of linear saving function: We know: S = Y - C and C = c + b(Y) Putting the value of C from above in S: S = Y - {c + b(Y)} S = -c + (1 - b)Y {Where: S = Saving; -c = Amount of negative saving at zero income level; 1 – b = MPS; Y = Income}

30. Derivation of Saving Curve from Consumption Curve Let us understand derivation of saving curve from consumption curve through Fig. 7.9. As seen in the diagram, CC is the consumption curve and 45° 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 (= –c). As a result, the 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.

31. Investment refers to the expenditure incurred on creation of new capital assets. It includes the expenditure incurred on assets like machinery, building, equipment, raw material, etc. which lead to increase in the productive capacity of an economy. The investment expenditure is classified under two heads: ( i ) Induced Investment (ii) Autonomous investment INVESTMENT FUNCTION

32. Induced Investment Induced investment refers to the investment which depends on profit expectations and is directly influenced by income level. It is income elastic, i.e. it increases with increase in income and vice-versa. As seen in Fig. 7.10, induced investment curve 'II' slopes upwards from left to right indicating that as income increases from OY to OY₁, investment increases from OM to OM₁.

33. Autonomous Investment: Autonomous investment refers to the investment which is not affected by changes in the level of income and is not induced solely by profit motive. It is income inelastic, i.e. it is not influenced by change in income. As seen in Fig. 7.11, the amount of investment remains constant at OI, irrespective of the level of income (OY or OY₁) in the economy. Autonomous investments are generally made by Government on infrastructural activities. The level of autonomous investment depends on the social, economic and political conditions of the country. So, such investments change when there is change in technology or discovery of new resources or growth of population, etc.

34. Basis Induced Investment Autonomous Investment Motive Driven by profit motive, depends on profit expectations. Done for social welfare and not for profit. Income Elasticity Income elastic, rises with income level. Income inelastic, unaffected by income level. Investment Curve Slopes upwards as it is income elastic (Fig. 7.10). Parallel to X-axis as it is income inelastic (Fig.7.11) Sector Mainly by private sector. Mainly by government sector. Comparison of Induced vs Autonomous Investment

35. According to Keynes, the decision to invest in a new project (i.e., private investment) depends upon two factors: Marginal Efficiency of Investment (MEI) Rate of Interest (ROI) DETERMINANTS OF INVESTMENT

36. Marginal Efficiency of Investment (MEI): MEI refers to the expected rate of return from an additional investment. MEI is determined by two factors: ( i ) Supply Price:  It refers to the cost of producing a new capital asset or the price at which a new asset of that kind can be supplied or replaced. For example, if a machine of ₹10,000 is replaced in place of an old machine, then ₹10,000 is the supply price. (ii) Prospective Yield:  It refers to net return (net of all costs), expected from the capital asset over its life time. For example, if the given machine is expected to yield receipts of ₹1,200 and running expenses will be ₹200, then the prospective yield will be: . In the given example, Marginal Efficiency of Investment will be:  

37. Rate of Interest (ROI): It refers to cost of borrowing money for financing the investment. There exists an inverse relationship between ROI and the volume of investment. At a high ROI, the investment spending will be less and vice-versa. Comparison of MEI with ROI: The profitability of an investment can be worked out by comparing MEI with ROI. If MEI > ROI, then investment is profitable. For instance, if an entrepreneur has to pay 12% rate of interest on the loan acquired by him and the expected rate of profit, i.e. MEI, is 20%, then he will surely go for the investment and will continue making investment till MEI = ROI.

38. 'Ex-ante' variable is the planned or expected value of variable, whereas, 'Ex-post' variable is the actual or realised value of the variable. Both these terms are generally used in context of saving and investment. There are two aspects of saving and investments: ( i ) Ex-ante Saving and Ex-ante Investment (ii) Ex-post Saving and Ex-post Investment EX-ANTE AND EX-POST SAVING AND INVESTMENT

39. Ex-ante saving: It refers to amount of saving which households (or savers) plan to save at different levels of income in the economy. The amount of ex-ante or planned saving is given by the saving function (or propensity to save). Ex-ante investment: It refers to 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, i.e., by investment demand function.

40. Equilibrium occurs when Ex-ante saving = Ex-ante investment. In an economy, equilibrium is determined when planned saving is equal to planned investment. However, both these concepts are equal only at equilibrium level of income. It happens because of three reasons: ( i ) Generally, saving is done by households and investment is done by firms. So, savers and investors are different people with different priorities. (ii) Saving is made in small amount and investment is made in big amounts. (iii) Saving is made for meeting future uncertain events or contingencies, whereas, investment is made for profit motive.

41. Ex-Post Saving and Ex-Post Investment Ex-post saving It refers to the actual or realised saving in an economy during a year. Ex-post or actual saving is the sum total of planned saving and unplanned saving. Ex-post investment It refers to the realised or actual investment in an economy during a year. Ex-post or actual investment is the sum total of planned investment and unplanned investment. It must be noted that ex-post saving and ex-post investment are equal at all levels of income. This equality between the two is brought by fluctuations in income.

42. Full Employment Full employment refers to a situation in which all those people, who are willing and able to work at the existing wage rate, get work without any undue difficulty. Under full employment, there can be 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. (ii) Structural Unemployment:  It refers to the unemployment, in which people remain unemployed due to a mismatch between unemployed persons and the demand for specific type of workers. Involuntary Unemployment Involuntary unemployment refers to unemployment in which all those people, who are willing and able to work at the existing wage rate, do not get work. FULL EMPLOYMENT & INVOLUNTARY UNEMPLOYMENT